February 28, 2017
Unlikely but Not Impossible
The Investment View from Prescott, Arizona
The 2017 Super Bowl is fading into old news, but it holds an important lesson for investors.
In that game, 24 Super Bowl records were topped and seven were tied.
Before the game got interesting in the 4th quarter, the announcers said that, surprisingly, no team in Super Bowl history had ever overcome a deficit of more than 10 points. The Patriots’ record-breaking comeback highlights an important truth about investing; the future may bring what the past has not.
As an analyst, I rely heavily on historical market environments and past price action to put today’s market and opportunities in context. And most of the time, keen insights from history are useful in charting a course forward into the great unknown.
But it’s also important to maintain a healthy dose of humility when it comes to foreseeing the future. You’ve got to leave the door open to the idea that we’ll never know, with certainty, exactly what tomorrow holds.
It’s the same concept as the Patriots’ record-breaking comeback. Just because 10-point deficits were the biggest that had been overcome didn’t mean that a bigger comeback wasn’t possible.
Unlikely… yes. But not impossible.
Last year was all about the unlikely-but-possible coming true. Everything that wasn’t supposed to happen did, Brexit and Trump, of course, being the biggest news.
It’s still too early to tell what history will say about 2017, but my guess is: many more surprises!
A Family Update
Several students from my very first class at Yavapai College in 1990 became clients over the years and whenever we would get together we would reminisce about the day when “the call came in” and I rushed out of class to the hospital just as Matt was being born. Most of those folks have passed away now. After all that was almost 27 years ago.
But many of you know Matt and regularly ask about him, so I wanted to provide an update.
Matt is married to Alison, who works at Fancy That clothes store and sells a little Mary Kay Cosmetics on the side. Matt is a barista at Wild Iris and is back with the Wes Williams Band, a really fun dance band. He quit the band last year because he wanted to stay home with his kids instead of touring, but they asked him back and have put touring on the back burner to accommodate him. They will be playing the Elks for Cinco de Mayo this year if you like to dance.
Matt has two children, Mal, short for Malorylin, a bright, quiet all-girl girl, and Caleb a smiley, talkative 2 ½ year old charmer who is all boy.
Matt has reached the age where he is leaving the kid-like ideas behind and is growing up right in front of my eyes. It’s fun watching the process.
What the Markets Are Doing
The US stock markets have broken out of their sideways trading range that existed from December into January, posting new highs in February. This actually defies historical trends which show a February pause after most new presidents are inaugurated.
Many sentiment indicators are pointing toward a dwindling number of potential buyers left, so a return to normal historical patterns in the stock market is probably in our future. For now however, the overall stock market is looking like an OK place to be.
Small company stocks are underperforming compared to large company stocks, a condition that signals a lack of liquidity which frequently causes an end to bull market runs.
Normally, financial markets ebb and flow, zig and zag and bob up and down. The bond markets went sharply down last year as interest rates rose, but are failing to bounce as one would expect.
The issue with interest rates is that the government pulled down interest rates after the 2008 financial crisis with a tactic akin to holding a cork underwater. Then they took the opportunity to refinance maturing government bonds with shorter term bonds to lower their interest costs even further.
According to the Treasury Department, 37% of US Treasury debt matures in less than 2 years and will need to be either paid off or rolled over.
Of course, paying off the debit is not going to happen with continuing federal deficits a certainty. Rolling it over at today’s 2-Year Treasury rates – currently twice as high as July 1, 2016 – will add many billions to our budget deficit. Time to pay the piper.
Look for interest rates to continue to rise as the government is forced to sell more bonds at ever higher rates to keep rolling over their debt.
Rising interest rates have one benefit, it makes our bonds more attractive to foreigners who have to first buy our dollars to pay for bonds, a process which keeps the dollar strong. Expect the recent strength in the dollar to continue, and don’t pay attention to the tabloids crying about the death of the dollar. Ain’t gonna happen.
Commodity markets are generally rising, signaling a heartbeat returning in flagging economies worldwide. If you believe that a Trump administration will bring rising deficits, then you should expect gold prices to rise over the next few years as they have started to do recently.
Bitcoin, a digital currency, hit all time highs this week on speculation that the SEC will approve of an Exchange Traded Fund (ETF) designed to hold Bitcoin. I consider Bitcoin to be the wild west of investments where there are few rules and anything can happen. A lot can go wrong to unhinge a small fragile market like Bitcoin. Things like the emergence of a competing digital currency, government rules to limit or block use of Bitcoin, IRS investigations (currently underway) or more scandals involving the use of Bitcoin as we had a few years ago. Anyone looking to enter the world of Bitcoin speculation might pause and consider the significant risks.
A Frequent Question
I am often asked why we don’t own Amazon stock (AMZN). Clearly Amazon is a leader in retail innovation, and almost everyone I know uses Amazon for retail purchases.
Personally, I love Amazon and did own it in our growth portfolios a couple of years ago, selling it when it hit a period of decline. The reason I hesitate to buy it back is due to earnings valuations (P/E ratios in technical terms), a common way of telling if a stock is cheap or expensive.
If one were to buy Amazon’s stock today (Feb 26, 2017) they would pay $172 for each $1 of Amazon earnings. This is about 10 times the stock market’s historic average. A valuation that high makes for a very unforgiving investment. Let me use the story of Chipotle as an example.
Some years back I also owned Chipotle stock (CMG) in client portfolios. I sold it during a price dip and chose not to buy it back when my research showed it to be way overvalued, similar to Amazon today.
To my chagrin, Chipotle continued on higher for a while, but then they had some food quality issues, people got sick and the price dropped 50% in months. As I said, the market is very unforgiving of any miscue by high valuation stocks. I don’t like to own stocks for which declines of that magnitude are a matter of "when," not "if."
So, as much as I like Amazon, I avoid their sky-high valuations as just too risky.
What We Were Saying Back Then
I often talk about volatility and how wildly fluctuating prices are one of an investor’s worst enemies.
An investor who rides out a market that goes down 25% then up 25% will still have lost over 6% of their investment. This is not voodoo economics; it is due to the math of gains and losses. The 25% loss begins from a larger amount of principal than the 25% recovery.
For this reason, I have developed several systems to manage volatility, especially in the go-go stocks used in my Future Technologies* strategy, currently 45% of Shock Absorber Growth* portfolios.
I recently came across some research that vividly shows that volatile prices, defined as 10%, and greater declines (shown in blue) come in clusters and can destroy portfolios if ignored.
This study shows that when volatility (risk) occurs, it tends to stay present for several years. Could 2015 and 2016’s sharp drawdowns be the beginning of another multi-year bout of dangerous volatility? We can’t know for sure.
At HCM, I proactively manage volatility in each of the 8 strategies that are blended together in our various portfolios. Wise investors should take steps to protect principal values in case volatility continues. Or, as Warren Buffet says, “When the tide goes out is when you see who was swimming naked.”
What's Going on in Your Portfolio?
In early January Shock Absorber Growth portfolios were positioned for a rough market that did not happen so we lost a bit of ground relative to the stock markets as a whole. Since I realigned our holdings in mid-January to the rising market, we have performed well.
Growth portfolios have about 80% exposure to the stock market as of this writing on February 26th. A couple of holdings hit sell triggers over the past two weeks and that money is being held in cash waiting for the market to correct a bit and give us a better entry point.
Flexible Income portfolios have been held back by the recent underperformance of our government bond strategy. This strategy has been one of our stronger performers over the past two years but is currently struggling with a trendless treasury market. I believe it will find traction as soon as the treasury markets enter a trend, as this strategy can make money regardless of whether Treasury prices are moving up or down.
Blended portfolios, which include Adaptive Growth (currently 80% Shock Absorber Growth and 20% Flexible Income) and Adaptive Balance (currently 50/50) are flat for the year, but are up in the past month and a half since I adjusted the portfolios for the strong stock markets.
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Safety and Soundness Flyer
You are driving a bus from New York City to Philadelphia.
In Staten Island, 17 people got on the bus.
In New Brunswick, 6 people get off the bus and 9 people get on.
In Windsor, 2 people get off and 4 get on.
In Trenton, 11 people get off and 16 people get on.
In Bristol, 3 people get off and 5 people get on.
And, in Camden, 6 people get off and 3 get on.
You then arrive at Philadelphia Station.
Without going back to review, how old is the bus driver ?
Don't you remember your own age?!?! It was YOU driving the bus!
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 equity-income investments 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.