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Dear Valued Client,
The newsletter is a few days late, as we spent last week conducting a review of all client portfolios. My concern was that as the market approached previous lows, the probability increased a good deal that it would drop below previous lows as indeed happened today. The first article below outlines my thoughts on the market and client portfolios, and explains trades we recently made or are in the process of making in most client accounts.
The ongoing economic turmoil is not without opportunity, either in the short term, or in the longer-term in terms of bargain priced stocks. The shorter term opportunties have been created both by government intiatives including the stimulus and the housing plans, and the usual suspects in the retail sector are resorting to price cuts to convince consumers to continue to spend. The second article highlights some of these bargains, and might be of particular interest to small business owners and those planning on purchasing a house or refinancing their existing mortgage.
The question of the month regards one facet of our current investment strategy, the use of Hussman Strategic Growth in lieu of large cap index funds we typically use. It's not at all surprising that many of the questions I hear these days are centered around investments and the markets. The times are as challenging economically as any we've seen in decades, and the news for the next few months isn't likely to get much better. Nevertheless, at some point, perhaps when the impact of the stimulus begins to be felt, news will improve and markets will improve with it. In the interim, we will continue to do what is necessary to preserve account values and enable you to continue to meet our financial goals.
As always, thank you for your trust, and don't hestiate to contact us if you have any questions.
Sincerely,
Micah Porter, CFA
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An Update on Portfolios and the Markets
Micah Porter, CFA
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In the year-end commentary, I wrote that it would not be surprising to see the markets retest their lows in the initial months of this year. I thought this might be the case because the December rally seemed to be based on optimism that a new administration would implement new economic initiatives and make existing initiatives (think TARP) more efficient. However, it seemed to me that it would take time before these initiatives had a demonstrable impact, and any optimism would be sorely tested in the interim as lousy economic and corporate data continued to rule the day.
I wasn't certain that the above scenario would play out, but it has, and my concern now is the market will continue to trend downward in the coming months, perhaps sharply so. If such a drop does occur, it won't be so much a reflection of valuation - several analysts we follow peg fair value on the S&P 500 in the 800 to 900 range - but rather of market psychology. Typically, market drops well below fair value are transitory, so if history is any guide, recovery back to fair value should happen during the bear market, particularly if the stimulus takes effect. As Ben Graham, Warren Buffet's mentor, was fond of saying, "In the short run, the market is a voting machine, but in the long run it is a weighing machine."
Normally, we wouldn't make changes to portfolios to avoid temporary loss in value. However, given the declines in market values and the level of volatility that still exists, we are positioning most portfolios more defensively. To achieve this, we are doing the following:
• Selling most or all of the large cap index positions, and moving to Hussman Strategic Growth Fund. Hussman is a long-short fund, which is a type of fund that employs defensive strategies to limit losses in a down market. Thus far, Hussman has done quite well, as it is up nearly 2% year-to-date versus a loss on the S&P of in excess of 13%.
• Shifting from more volatile bond funds to bond funds that we believe will be less volatile.
The overall goal here is to continue to remain invested in the market, but to do so in a way that provides more downside protection. What we're not doing is selling while the market is down - while that might be tempting given the news of late, that has generally been a losing strategy over the long-term.
The end result of the above trades along with other portfolio changes we've implemented is that most portfolios have 35% to 50% lower exposure to unhedged equities* than would normally be the case. Thus, a portfolio that would normally be 60% in equities and 40% in cash and fixed income is now 30% in unhedged equities and 60% in cash, fixed income and Hussman.
The net result of such a portfolio is to greatly limit further declines, particularly if the bond portion of a portfolio holds its ground or advances as the equity markets slide.
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* By unhedged equities, I mean all equity mutual funds other than Hussman, as Hussman is the only equity fund that uses as a cornerstone of their strategy equity options and other instruments to limit loss.
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Financial Planning Tips - Opportunities during the downturn
Micah Porter, CFA
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As the saying goes, during challenging times like these “cash is king”. That’s the natural result of a free market - sellers pursue buyers more aggressively when there are fewer buyers to be found. Prices drop and deals abound, and this downturn is no exception. However, given the severity of this particular downturn, not only are many more sellers willing to negotiate than is normally the case, but the government has gotten in on the act. The recently passed stimulus package and other government initiatives are designed to assist numerous sectors of the economy, consumers included.
So how might recent government action benefit you? Here are those provisions most likely to impact you or those you know:
• Lower mortgage rates - the housing plan announced last week is a multi-pronged approach to addressing the rising tide of foreclosure. However, one element - an attempt to lower interest rates by shoring up Fannie and Freddie - is likely to benefit a wide swathe of homeowners, not just those facing foreclosure. According to Freddie Mac, the average 30-year conventional mortgage rate was 5.09%, and if the government is successful, rates could go still lower. Our advice is to keep an eye on rates if you have a mortgage, as refinancing might make sense and to call us if you want to discuss whether you should refinance.
• Additional Housing Assistance - although the other housing initiatives likely won’t help most of our clients, we did want to make you aware of them as they may be of use to family and friends. The two initiatives we would highlight are one which allows more homeowners to refinance at lower rates, and another directed at first-time homebuyers. Details are as follows:
• Refinancing at lower rates - although rates have dropped, many homeowners have not been eligible for refinancing as their homes have dropped in value. One of the key ratios lenders examine is the loan-to-value ratio, or LTV and typically refinancing into a confirming loan with an LTV of greater than 80% isn’t possible. Thus, even those who bought a house in recent years and put 20% down or more and had solid credit and income might not be able to refinance. By directing Fannie and Freddie to lift this limit, the government has enabled a greater percentage of those whose loans are held by Fannie and Freddie and who otherwise would be credit worthy to refinance. Here’s an example from the blog Calculated Risk of how this might work:
Consider a family that took out a 30-year fixed rate mortgage of $207,000 with an interest rate of 6.50% on a house worth $260,000 at the time. Today, that family has about $200,000 remaining on their mortgage, but the value of that home has fallen 15 percent to $221,000 – making them ineligible for today’s low interest rates that now generally require the borrower to have 20 percent home equity. Under this refinancing plan, that family could refinance to a rate near 5.16% – reducing their annual payments by over $2,300.
• First time buyer credit - there has long been a tax credit for first time home buyers. However, for 2009 that credit has been increased to $8,000, payback is no longer required and the credit can be split over two years.
• Tax breaks - the stimulus package included tax breaks for those working, as well as for those drawing social security. The “Making Work Pay” initiative is designed to lower payroll withholding by $400 per individual or $800 per family per year. For those receiving social security, you will receive a one-time $250 payment later this year.
• New Car Purchase - if you spend up to $49,500 to buy a new car in 2009, you can deduct state and local sales tax paid on the car. While this isn’t a huge deduction, it can result in a few hundred dollars savings, and you don’t have to itemize to claim this deduction.
• Breaks for small businesses - there are a number of tax breaks for small businesses, and the details are beyond the scope of this letter. In addition, the Small Business Administration is expanding their loan programs, including a program to loan up to $35,000 essentially interest free to businesses to be used to pay down existing, higher interest rate loans.
Government initiatives aside, as a consumer don’t hesitate to use the leverage you have. As I said at the outset, cash is king, and if you need to make a purchase chances are you can get a pretty good deal.
I have spoken to a number of clients in recent weeks who have gotten deals on everything from mattresses to clothing. And while retailers are offering deep discounts, so are many companies that don’t normally offer discounts. Restaurants from the high end down are offering more specials, and even cable, phone and cellular companies are lowering rates with minimal change in services or offering free service for a time to keep customers from leaving.
Hopefully these tips are useful for your family and friends.
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Client Question of the Month
Micah Porter, CFA
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In moving from large cap index funds like DFA Large Value and the S&P 500 index fund to Hussman Strategic Growth, how does this differ from “selling low” or trying to time the market?
When we move from an index fund to the Hussman long-short fund, we are selling low, but we are also buying low. It’s important to realize that a long-short fund is made up of two portions - the “long” portion of the fund in which the fund holds stocks just like a standard mutual fund. In fact, on the long side of the fund, Hussman is a value investor as are many of the managers of the other funds we use.
The short side of the fund is where things differ from the other funds we use. While Hussman is a long-short fund, they are currently relying primarily on equity index options to protect against the downside. This is important, because while shorting a stock will generally work against you in a rising market, options do not, particularly if the market increases sharply in value. Thus, if Hussman’s strategy is successful, investors have downside protection, while being able to participate in the upside. As with any investment, there are no guarantees that he will successfully execute his strategy, but over the past nine years, and even through the tumult of the last five months, the fund has held up well.
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