Investing Successfully In A Recession

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
February 5, 2008

IN THIS ISSUE:

1.   Is The Economy Headed For Recession?

2.   Can Rate Cuts & Stimulus Detour A Recession?

3.   Is It Too Late To Jump Into Bonds?  No.

4.   Revisiting Hg Capital Advisors’ Bond Program 

5.   Hg’s Actual Past Performance Record

6.   Details On How To Get Started

Introduction

The latest economic news, on balance, has been quite disappointing, and unless upcoming reports are stronger than expected, it now looks very likely that the US economy will experience negative growth in GDP for at least the 1Q of this year.  It is still too early to conclude that the US economy is headed into a recession, but the odds continue to increase.  I will summarize the latest economic reports in the pages that follow.

The Fed continued to slash short-term interest rates again last week by cutting the Fed Funds rate another 50 basis points to 3%, following the unexpected 75 bips cut just nine days earlier.  This rate cutting campaign that began last September has seen the Fed cut short rates by 2.25% - one of its most aggressive moves in decades.  Obviously, the Fed is serious about heading off a recession but the question remains, will the rate cuts be enough to reverse the housing slump and subprime woes?

After falling precipitously since the peak in October, stocks rebounded modestly over the last two weeks following the surprisingly large Fed rate cuts.  I doubt, however, that this downward correction in US equities is over yet.  It will not surprise me if stocks go into a broad trading range with a downward bias over the next few months as this correction plays out.

With the substantial cuts in interest rates by the Fed, the bond market has moved sharply higher as rates have come down.  While rates still have some room to come down, I think that most of the move is over, what with the 30-year Treasury bond yield down to around 4.5%.  Like stocks, I think bonds most likely move into a broad trading range for most of this year.  And herein lies a great opportunity for sophisticated investors. 

In my October 2 E-Letter, I introduced you to Hg Capital Advisors, the latest professional money manager to make it onto my recommended list.  Specifically, I introduced you to Hg’s Long/Short Government Bond Program.  This program delivered outstanding results in 2007, when many money managers stumbled, and it had another great month in January.  We will revisit Hg Capital’s Long/Short Government Bond Program in the pages that follow, as I believe it could be a great strategy for the bond market environment this year.  (As always, past results are not a guarantee of future results.)

Is The Economy Headed For Recession?

As noted above, most of the economic reports in January were disappointing.  Last Wednesday, the Commerce Department reported that 4Q GDP rose only 0.6% (annual rate), following the 4.9% rate in the 3Q.  The pre-report consensus was for a number in the 1.2% range, so the announcement came as quite a surprise to the markets.

The Labor Department announced on Friday that the unemployment rate fell from 5.0% in December to 4.9% in January.  However, the government also reported that non-farm payroll employment actually declined in January.  For the first time in the last five years, there was a net decrease in employment in January. 

The state of the labor markets will play a big role in determining how severe this economic slowdown will be.  People who have jobs will continue to spend and fuel the economy.  Unfortunately, jobless claims rose by 69,000 for the week ended January 26, the largest weekly increase in over a decade.

The Conference Board reported last week that the Consumer Confidence Index fell from 90.6 in December to 87.9 in January.  The January decline erased the minor increase in December, and the Index has been in a virtual freefall since mid-summer.  The University of Michigan Consumer Sentiment Index also fell again in January.  Consumer spending actually rose modestly by +0.2% in December (latest data available), but with confidence falling sharply, we could see spending decline over at least the next few months.

News on the housing front continues to worsen.  The Case-Shiller U.S. Home Price Index for the 20 largest cities fell over 8% in 2007 alone.  New and existing home sales, housing starts and building permits all continued to decline in December.  RealtyTrac reported last week that the number of home mortgages going into default or foreclosure soared by 75% in 2007 alone.  The Senate is now considering a new federal agency, dubbed the Home Ownership Preservation Corp., that would spend billions of taxpayer money by buying troubled mortgages and allowing homeowners to refinance at lower rates.  I hope this doesn’t happen, but it is an election year.

Congress is hastily moving forward with its economic stimulus package.  The House passed a $150 billion giveaway package, which the president indicated he would sign.  But as this is written, the Senate is considering an even bigger stimulus package that may include an extension of unemployment benefits, increased foodstamps and a possible special rebate for seniors.  As I predicted in these pages two weeks ago, the economic stimulus package will be larger than what President Bush asked for, and the budget deficit for fiscal 2008 will be enormous.

In addition to the 1.25% combined rate cut in late January, the Fed is expected to cut rates another 50 basis points at the next FOMC meeting on March 18 – if not before.  In its policy statement on January 30, the FOMC noted: “The Committee will continue to assess the effects of financial and other developments on economic prospects and will act in a timely manner as needed to address those risks.”  This is Fed-speak for more cuts are coming as needed.

Can Rate Cuts & Stimulus Detour A Recession?

Most of my respected sources now believe a recession in 2008 is unavoidable.  As noted above, with GDP slowing so sharply in the 4Q, it is not a stretch to predict that GDP will be negative in the 1Q of this year.  Some predict the recession will last 2-3 quarters, with a rebound late in the year, while others believe it will be more severe – at least one year.  And, of course, the gloom-and-doom crowd promises we’re headed for a depression.

But a new forecast from the International Monetary Fund (IMF) has a more optimistic take.  The IMF revised its forecasts for 2008 and predicts the US economy will skirt a recession this year with GDP growth of 1.5% on average, down from 2.2% for 2007.  The IMF lowered its forecast for global economic growth from 4.9% in 2007 to 4.1% in 2008.  Emerging markets are expected to grow by 6.9% on average, with China slowing to a 10% growth rate, according to the IMF’s latest forecasts released last week.

It remains to be seen, of course, whether a combination of the stimulus package and further rate cuts from the Fed can detour a recession this year.  Remember, a recession is two or more consecutive quarters with negative growth in GDP.  Time will tell, but based on historical averages, we are overdue.

Is It Too Late To Jump Into Bonds?  No.

Whether we have a recession this year remains to be seen.  Ditto for how serious it may be.  One thing is for sure: we are in an economic slowdown, and that is not good for the stock markets.  On the other hand, interest rates tend to fall during economic slowdowns and recessions.  As noted above, we have already seen a sizable drop in interest rates, and there may be more to come.  This means there could still be some good opportunities in the bond markets. 

There are some who believe that the 30-year US long bond, now around 4.5%, could go as low as 3%, but generally speaking that assumes a very serious recession.  I don’t expect the 30-year Treasury bond to go to 3%, but it can’t be ruled out.  The question is: Is it too late to get on the bond bandwagon?  Normally, I would say yes, but that was before we added Hg Capital Advisors to our recommended list of professional money managers.  Hg has a proven strategy that goes both long and short in the 30-year Treasury bond via mutual funds.

As noted in the Introduction, I expect interest rates, including T-bonds, to continue lower a bit longer, but at some point this year, I expect rates to bottom and move into a broad trading range that could last for some time.  This is why I think you should take a closer look at Hg Capital which had a great year in 2007 (the last three years, actually) and a great start in January.  Please read on.

Revisiting The Hg Capital Long/Short Government Bond Program

As I noted above, I introduced the Hg Capital Advisors Long/Short Government Bond (LSGB) Program in my October 2, 2007 E-Letter.  This program seeks to provide short-term capital gains by trading the Rydex mutual funds designed to provide a leveraged long and short exposure to the price movements of the US Treasury 30-year long bond. 

Now that we have been offering this program to our clients for a few months, I think it’s a good idea to let you know how it has fared, especially in light of the Fed’s recent actions and the stock market’s steep decline.

To make a long story short, Hg’s LSGB Program ended 2007 with a total gain of 16.83%, net of all fees and expenses.  Even more exciting is the news that in January, when most equity programs were suffering, our LSGB test account had an estimated gain of 5.55% net of fees.  Of course, past performance is not necessarily indicative of future results.

I’ll discuss other performance numbers and benchmark comparisons a little later on.  Before that, however, let me briefly give you some of the background about Hg Capital Advisors and their proprietary strategy for trading US Treasury long bond mutual funds on a long and short basis.

As I noted in my October 2, 2007 E-Letter, the principals of Hg Capital Advisors are Byron Haven, Ted Lundgren and Dennis Shaw.  Each of these three individuals brings different skill sets and past experience to the table, resulting in a synergy of sorts.  After years of research and development, the result of this synergy is a 100% mechanical trading model designed to anticipate the price movement of the 30-year Treasury bond – up or down.

The Hg Long/Short Government Bond Program began trading in late 2004, so its actual track record reached the three-year milestone in 2007.  It is very impressive, as you will see below.  Not surprisingly, their performance has attracted a lot of attention from investors across the country.  As a result, Hg has gone from virtual obscurity in 2004 to managing over $100 million for hundreds of clients nationwide.

Hg has outsourced administrative and trading tasks by forming a business relationship with Purcell Advisory Services of Tacoma, Washington. Each day, Hg communicates its trading signals to Purcell, where the trades are executed and client accounts are maintained.  Purcell provides similar services for other Advisors recommended by HWM.

The Long/Short Government Bond Trading Model

Hg Capital’s trading model is based on a number of what they call “rules,” which have been incorporated into their strategy.  In essence, these rules are actual observations of historical market activity, as opposed to conceptual ideas of how it “might work” or “should have worked.”

The primary emphasis of the bond model is an analysis of interest rate data.  Each day, Hg Capital enters current interest rate data into their computer system, and their software analyzes literally thousands of rules in order to determine which single rule is the most likely, from a statistical standpoint, to be indicative of the market’s action during the next trading day.  As you might imagine, the computing power necessary to run this analysis is extensive.

It is important to note that the Hg Capital methodology is only concerned about the market’s expected movement over the next trading day.  It does not attempt to predict what the market may do over the next week, month or year.  The Hg trading model is 100% mechanical, and no discretion is involved.  If their signal indicates that T-bond prices are likely to go up the next day, they take (or hold onto) a “long” position in the Rydex bond fund they use.  On the other hand, if their signal indicates that T-bond prices are likely to go down the next day, they take (or hold onto) a “short” position in the Rydex bond fund. 

Because Hg’s LSGB Program trades both long and short, and because they do not use formal stop-loss orders, this is an aggressive strategy, and should not be considered as an option for investors who want only a buy-and-hold Treasury bond exposure, or who are looking for interest income. 

Performance Evaluation

As I discussed above, the LSGB Program had impressive results for both the year of 2007 as well as for the month of January, 2008.  The performance information provided below shows that the strategy also performed very well when compared to both bond and equity benchmarks, and over a variety of time windows.  Plus, the LSGB Program has been virtually non-correlated to the broad stock or bond markets in the past, as well as to the other investment programs offered by Halbert Wealth Management.

Since its inception in November of 2004, the Hg Capital Advisors Long/Short Government Bond Program has posted an estimated average annualized compound return of 21.50% as of the end of January 2008, net of fees.  The worst-ever month-end losing period (or “drawdown”) was -8.76%, which occurred during the recent subprime meltdown.

The chart below provides a time window analysis of the LSGB Program’s performance as compared to both equity and bond indexes.  As you can see, the LSGB Program has fared well as compared to both equities and bonds.  Since it is not just a long-only strategy, it has the potential to profit from both up and down moves in the price of the 30-year Treasury bond.

 

Hg Capital Long/Short Govt. Bond

Vanguard Long-Term US Treasury Bond Index Fund

S&P 500 Index

1-year

16.83%

9.24%

5.49%

3-year

19.55%

5.84%

8.62%

Jan. 2008

5.55%

2.64%

-6.12%

Actual performance record (annual average) as of 12/31/2007, net of fees.

Click on the following link to see more actual performance information on the Hg Capital LSGB Program as of 12/31/2007, including additional benchmark comparisons and detailed monthly returns.  Past performance does not guarantee future success.  Also be sure to read additional important disclosures at the end of this E-Letter.

While actual drawdowns have been relatively small in the LSGB Program, it is important to remember that the actual track record is relatively short.  When asked about the potential for drawdowns over time, Hg’s principals indicated that, in extreme market conditions, drawdowns could potentially reach -20% or more, again confirming its aggressive nature. 

A Non-Correlated Alternative

Since Hg manages the Rydex long bond mutual funds for capital gains rather than interest income, you may be wondering why you should consider this program, since it is so much like actively managed equity investments.  After all, if the Advisor is managing the asset for capital gains, what does it matter whether it’s a stock or bond?

That’s a very good question.  The answer is that the potential for capital gains, both long and short, generally occur independently from those of equity investments.  As a result, successful trading activities can produce a return that has little or no correlation with either equity or bond indexes.  Non-correlated investments are often preferred because they have the potential for gain without respect to how any other investment in the portfolio may perform.

The chart below will illustrate this concept.  It shows the extent to which Hg Capital’s LSGB Program’s performance is correlated to major stock and bond market indexes.  A value of 0.700 to 1.000 is indicative of a high correlation, values between 0.400 and 0.700 indicate a moderate correlation, and values below 0.400 indicate little or no correlation. 

Market Indexes:

Hg LSGB Program
R-Squared Correlation

 

 

S&P 500 Index

0.004

Nasdaq Composite Index

0.000

Lehman Long Government Index

0.150

 

The above R-Squared correlation analysis covers a period of time from the inception of the Hg LSGB Program in December 2004 through December 31, 2007. Past R-Squared Correlation of the Hg LSGB Program to these indexes and other investment programs is not necessarily indicative of future correlation, and there is no guarantee that these numbers will not change significantly over time. Be sure to read the Important Notes at the end of this E-Letter.

 

This chart makes it easy to see that the LSGB Program has had virtually no correlation with the major stock market indexes in the past three years.  It even goes one better by not having a high historical correlation to the Lehman Long Government Bond index, which approximates what a buy-and-hold position in the long bond would return.  Of course, there are no guarantees that the LSGB Program’s correlation to major industry benchmarks and other AdvisorLink® programs will continue to be low in the future.

Why You Should Consider The LSGB Program Now

Back in October, I said that Hg Capital’s Long/Short Government Bond Program may be an excellent way to include an actively managed Treasury bond exposure in a diversified portfolio.  If anything, I’m more convinced of that in today’s equity and interest rate environments. 

One reason I believe this to be true is that the LSGB Program offers the potential to make money in both rising and falling interest rate environments, by trading long and short, which is attractive to many investors.  If interest rates and the bond markets act like I expect them to in 2008, I believe the Hg Capital Long/Short Government Bond Program might be one of the best places to be invested.

Another good reason to consider this program is the fact that it is generally not correlated with other investments you are likely to be holding.  While many investors are searching for international and even emerging market funds in an effort to find non-correlated alternatives, the LSGB Program has consistently shown the historical ability to produce superior returns that are not correlated to other stock and bond asset classes.

A final reason to consider this investment is the strength of the Hg Capital team.  We were very impressed with the knowledge and integrity of all three of Hg’s partners.  With each bringing a different strength to the table, they have been able to develop the necessary synergy to enable them to truly build a trading model that is better than the sum of its parts. 

While no one can guarantee future performance, I feel comfortable that Byron, Ted and Dennis all believe that they have done everything within their power to incorporate all of their collective knowledge and experience into this trading program.  As a result, they have complete confidence that it’s the best long bond program they could build on behalf of their clients.

However, the LSGB Program should not be viewed as a conservative bond investment.  Many investors include Treasury bonds in their portfolios for the safety and security of the asset class.  While that’s generally true if you buy and hold individual bonds to maturity, it is important to note that this is not the case when bonds (or bond mutual funds) are frequently traded, and especially not when long and short positions are taken. 

Other aggressive factors of the LSGB Program include that it never seeks the safety of cash, so it will be either 100% long or 100% short all of the time.  In addition, the long side of the LSGB Program is leveraged and trades at a level of 1.2 times cash.  Thus, you should consider the LSGB Program only if you can tolerate a significant amount of performance volatility as well as the potential for double-digit drawdowns from time to time.

Details On How To Get Started

Fortunately, the process is simple.  Once you have determined that Hg’s bond program is suitable for you, we will send you the application to establish your own account with Rydex.  We also send you the Advisory Agreement which authorizes Purcell Advisory Services to make the trades in your account based on Hg’s signals.  Surprisingly, the minimum account size for the Hg LSGB Program is only $25,000.

The management fee is 2.5% annually, which is deducted from the account quarterly.  A portion of that fee is paid to HWM for introducing the client.  We monitor Hg’s performance daily, and should we ever believe you should close your account, we will notify you immediately.  How do we monitor Hg’s performance daily?  Because I have a chunk of my own money invested in the program.

I encourage you to check out Hg Capital Advisor’s Long/Short Government Bond Program CLICK HERE and see how it fits with your other investments.  Be sure to read the Important Notes and disclaimers below. If you would like to have assistance in this review, feel free to call one of our Investment Consultants at 800-348-3601 or e-mail us at info@halbertwealth.com and we’ll be happy to help you.  You can also obtain additional information and contact us via our website at www.halbertwealth.com, or by completing one of our Hg Capital Long/Short Government Bond Program online request forms.

Wishing you profits,

Gary D. Halbert

SPECIAL ARTICLES:

Hung Jury on Economy's Direction
http://www.ftportfolios.com/Common/CommentaryContent/MarketCommentary-875.pdf

Signposts for Super Tuesday
http://www.slate.com/id/2183602

Republicans For Hillary
http://www.realclearpolitics.com/articles/2008/02/republicans_for_hillary.html

Dole Scolds Limbaugh
http://www.politico.com/news/stories/0208/8314.html

IMPORTANT NOTES:  Halbert Wealth Management, Inc. (HWM), Hg Capital Advisors, LLC, and Purcell Advisory Services, LLC (PAS) are Investment Advisors registered with the SEC and/or their respective states.  Information in this report is taken from sources believed reliable but its accuracy cannot be guaranteed. Any opinions stated are intended as general observations, not specific or personal investment advice.  Please consult a competent professional and the appropriate disclosure documents before making any investment decisions. There is no foolproof way of selecting an Investment Advisor. Investments mentioned involve risk, and not all investments mentioned herein are appropriate for all investors.  HWM receives compensation from PAS in exchange for introducing client accounts to the Advisors.  For more information on HWM or PAS, please consult Form ADV Part II, available at no charge upon request. Any offer or solicitation can only be made by way of the Form ADV Part II.  Officers, employees, and affiliates of HWM may have investments managed by the Advisors discussed herein or others.

As benchmarks for comparison, the Standard & Poor’s 500 Stock Index (which includes dividends) and the Vanguard Long-Term US Treasury Bond Index Fund represent an unmanaged, passive buy-and-hold approach.  The volatility and investment characteristics of these benchmarks cited may differ materially (more or less) from that of the Advisor.  The performance of the S & P 500 Stock Index and the Vanguard Long-Term US Treasury Bond Index Fund is not meant to imply that investors should consider an investment in the Hg Capital Long/Short Government Bond (LSGB) trading program as comparable to an investment in the “blue chip” stocks that comprise the S & P 500 Stock Index or the Treasuries that comprise the Vanguard Long-Term US Treasury Bond Index Fund.  Historical performance data represents an actual account in a program named Hg Capital 199Hg-TYX, custodied at Rydex Series Trust, and verified by Theta Investment Research, LLC.   Since all accounts in the program are managed similarly, the results shown are representative of the majority of participants in the Program.  Purcell Advisory Services utilizes research signals purchased from Hg Capital Advisors, an unaffiliated investment advisor.  The signals are generated by the use of proprietary software developed by Hg Capital Advisors.  Statistics for “Worst Drawdown” are calculated as of month-end.  Drawdowns within a month may have been greater. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.  Mutual funds carry their own expenses which are outlined in the fund’s prospectus.  An account with any Advisor is not a bank account and is not guaranteed by FDIC or any other governmental agency.

When reviewing past performance records, it is important to note that different accounts, even though they are traded pursuant to the same strategy, can have varying results.  The reasons for this include: i) the period of time in which the accounts are active; ii) the timing of contributions and withdrawals; iii) the account size; iv) the minimum investment requirements and/or withdrawal restrictions; and v) the rate of brokerage commissions and transaction fees charged to an account. There can be no assurance that an account opened by any person will achieve performance returns similar to those provided herein for accounts traded pursuant to the Hg Capital LSGB trading program.

In addition, you should be aware that (i) the Hg Capital LSGB trading program is speculative and involves a high degree of risk; (ii) the Hg Capital LSGB trading program’s performance may be volatile; (iii) an investor could lose all or a substantial amount of his or her investment in the program; (iv) Purcell Advisory Services will have trading authority over an investor’s account and the use of a single advisor could mean lack of diversification and consequently higher risk; and (v) Hg Capital LSGB trading  program’s fees and expenses (if any) will reduce an investor’s trading profits, or increase any trading losses.

Returns illustrated are net of the maximum management fees, custodial fees, underlying mutual fund management fees, and other fund expenses such as 12b-1 fees.  They do not include the effect of annual IRA fees or mutual fund sales charges, if applicable. No adjustment has been made for income tax liability.  Money market funds are not bank accounts, do not carry deposit insurance, and do involve risk of loss.  The results shown are for a limited time period and may not be representative of the results that would be achieved over a full market cycle or in different economic and market environments.

 


Read Gary’s blog and join the conversation at garydhalbert.com.


Forecasts & Trends E-Letter is published by ProFutures, Inc. Gary D. Halbert is the president and CEO of ProFutures, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, ProFutures, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.

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