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The Fed Blinks, Now What?

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
February 23, 2010

IN THIS ISSUE:

1.   The Fed Blinks

2.   What’s the Outlook for Treasury Bonds?

3.   Revisiting the Hg Capital Advisors’
      Long/Short Government Bond Program

4.   Performance Evaluation

5.   Is This Program Right For You?

Introduction

The Fed’s action last week to raise the discount rate paid by banks that borrow money from the Fed is now old news.  However, the reverberations of this action are still being felt in both the stock and bond markets.  While the Fed’s decision was not necessarily a surprise in light of recent comments by Chairman Bernanke and FOMC minutes, the swiftness with which action was taken did shock the markets somewhat.

Investors want to know where they can invest now to get a return on their money.  One likely target is the long-term Treasury bond, or “long bond,” since its price is highly sensitive to changes in interest rates.  Now that government intervention in the credit markets may be coming to a close, many investors are looking for long Treasury bond prices to fall and are seeking ways to capitalize on this expected price trend.  However, there are still other factors, such as the recent Greek sovereign debt situation, that can affect bond prices in the opposite direction, so shorting Treasuries could be a recipe for disaster.

While I can’t tell you which way long-term Treasury bond prices are headed in the near term, I can say that there is a way for aggressive investors to potentially take advantage of this market, no matter which way bond prices head.  Back in 2007, I first wrote about the Hg Capital Advisors Long/Short Government Bond (LSGB) Program.  The LSGB Program is a mutual fund-based strategy that employs a combination of long/short trading and leverage in an attempt to realize capital gains based on price movements of the 30-year Treasury bond. 

In the remainder of this week’s E-Letter, I’m going to discuss the Fed’s latest action and what may lie ahead.  In addition, I’ll revisit Hg’s Long/Short Government Bond Program and tell you why I think it may be a good investment for aggressive investors who want to capitalize on the long bond’s price movement.  In 2009, the LSGB Program posted a gain of over 60%, net of all fees and expenses.  While past performance can’t guarantee future results, The LSGB Program may be worth consideration for the aggressive portion of your portfolio.

The Fed Blinks

Late last Thursday, the Fed took what could be the first step in a process to mop up some of the excess money supply and get on the road to raising interest rates.  The Fed discount rate, the rate at which banks can borrow money from the Fed, was raised from 0.5% to 0.75%.  While this move alone is not all that significant, it’s what the Fed may be thinking that will affect the markets.

Many analysts expected the Fed to make such a move after Chairman Ben Bernanke’s recent comments about plans to phase out subprime-era lending programs to banks and businesses.  The January FOMC meeting minutes also mentioned an increase in the discount rate.  Thus, this move was not a surprise and was generally seen to be a symbolic gesture.

Investors, however, took the Fed’s move as a signal that it may be phasing in an exit strategy to remove all or most of the excess liquidity it has pumped into the system since the credit crisis began.  Accordingly, immediately after the announcement, stock futures began to react negatively to the news, and Treasuries extended their losses.  The discount rate hike also boosted the US dollar, which automatically affected gold and other commodities prices.  Observers said that the stock and bond markets weren’t as surprised by the news as they were by the timing – at 4:30 PM EST on a Thursday afternoon.

Over the course of the subprime debacle and resulting recession, the markets and the Federal Reserve have been engaged in a staring match, each trying to determine the next move of the other.  The Fed has blinked and now it’s up to investors to decide how to position themselves to ride out the exit strategy. 

While few analysts believe that the fed funds rate will be increased anytime soon, the swiftness with which the discount rate was raised after first being mentioned in FOMC minutes makes anything possible.  I suspect that the Fed is using the hike in the discount rate as a trial balloon to see how markets react to the thought of tighter monetary policy.

While expectations of the Fed raising interest rates would place negative pressure on 30-year Treasury bond prices, there are still plenty of other forces beyond traditional fundamentals that have the potential to exert up and down pressure on long bond prices, including:

  1. We know that much of the action in Treasury bonds over the past couple of years has been due to massive government intervention in the credit markets.  While the Fed is signaling that its easy money policy may be coming to an end, this could abruptly change if we encounter worsening problems with unemployment, foreclosures and/or lower consumer spending.  A renewed need for government stimulus and other easy money policies could again affect short-term price trends in Treasuries.

  2. The US economy and markets are also not immune from global contagion, as we recently experienced with the Greek sovereign debt issue.  While this crisis may be averted, several other countries’ sovereign debt is at risk as this is written.  Any major default on sovereign debt could counteract any downward pressure from the Fed on Treasury bond prices.

  3. Most analysts feel that inflation is subdued and will not raise its ugly head for the foreseeable future.  I have to say that I tend to agree for the short term, but further out I think that our ballooning deficits and national debt will come home to roost in the form of higher inflation.

  4. Finally, we have the issue of continued financing of our huge government debt.  No matter whether you’re a conservative or a liberal, you have to agree that the expected doubling of our national debt over the next decade will have an effect on interest rates, and thus bond prices.  Will foreign governments continue to buy our bonds at rock-bottom yields, or will they insist on a higher return to compensate for our spendthrift ways?

The bottom line is that there are good reasons for 30-year Treasury bond prices to go up or down as we slowly unwind the unprecedented financial and fiscal stimulus that has been pumped into the economy.  As a result, it may make sense to have a small allocation to an aggressive investment that can potentially take advantage of market trends in either direction.  The Hg Capital Advisors Long/Short Government Bond Program is such an investment.  Read on to learn more about this dynamic investment.

The Hg Capital Long/Short Government Bond Program

As I noted back in 2007 when I first introduced Hg Capital, we had been searching for an effective program that could actively manage the 30-year T-bond on a long and short basis.  Since the long bond price can be subject to significant volatility, it naturally lends itself to a strategy that seeks potential capital gains that these price movements can produce. 

The Hg Capital Advisors Long/Short Government Bond Program seeks to provide short-term capital gains by trading the Rydex mutual funds designed to provide a long and short exposure to the price movements of the current US Treasury 30-year bond.  The Hg strategy is a proprietary trend-following model with overbought and oversold signals also having an input.

However, Hg Capital’s LSGB trading model isn’t your run-of-the-mill trend following strategy.  Hg has identified a number of what they call “rules” and has incorporated them into their model. 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.”

Each day, Hg Capital enters current market 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.

The primary emphasis of the bond model is an analysis of interest rate data, or yield.  As bond yields indicate a developing trend, the Hg trading model will buy either a long or inverse (short) Rydex long-term Treasury bond mutual fund, depending upon the direction of the move.  The model can also trade based on overbought or oversold conditions in the market.  If the model cannot detect a tradable trend, it will issue a signal to go to cash (money market).  However, cash positions are relatively rare, historically amounting to less than 10% of trading days.

Hg Capital’s methodology does not attempt to predict what the market may do over the next week, month or year.  All it is concerned with is the next day’s market action.  If the model happens to be long 20 days in a row, this doesn’t mean they got a signal saying the market will go up for 20 days.  Instead, it means they got 20 independent signals on 20 consecutive trading days that all said the program should be long.  In fact, this string of long trades could have theoretically been caused by 20 different rules gaining prominence on each of the 20 trading days.

The Hg trading model is 100% mechanical, and Hg will not override a signal, even in the case of a national emergency.  Hg’s statistical analysis indicates that their system is right approximately 58% to 60% of the time, based on daily data.  Our historical month-end performance analysis shows the bond program had a positive monthly return approximately 66% of the time, but past performance does not guarantee future results.

Hg’s methodology does not employ any formal stop-loss techniques.  However, since no signal lasts for more than one trading day, the effect of a bad trade may be limited by its short duration.  Hg is quick to point out that the Long/Short Government Bond Program is aggressive, and should not be seen as an option for investors who want only a buy-and-hold Treasury bond exposure or interest income.

Performance Evaluation

The detailed performance information below shows that the LSGB Program compares very well to both equity and bond benchmarks over a variety of time periods.  The LSGB Program is also virtually non-correlated to the broad stock and bond markets, as well as to the other investment programs offered by Halbert Wealth Management, as I will discuss in more detail later on.

Since its inception in December of 2004, the Hg Capital Advisors Long/Short Government Bond Program has posted an actual annualized return of 17.27% as of the end of January 2010, net of all fees and expenses.  The worst losing period (or “drawdown”) was –25.01%, which occurred during the recent subprime meltdown.  (See a more detailed discussion about the worst drawdown below.)  The charts and tables below show detailed actual performance, net of all fees.  Past performance does not guarantee future success.  Also be sure to read additional important disclosures at the end of this E-Letter.

Click to view full image
(Click to view full image.)

Note that the worst drawdown of -25.01%, measured as of month-end, occurred during the worst of the subprime crisis and credit crunch in 2008.  Astute readers may recall my original introduction to the Hg Capital LSGB Program back in 2007 disclosed that the strategy had no cash or “neutral” position at that time.  As a result, the model had no way to go to a neutral position when the global credit markets came to a standstill in 2008.  Accordingly, we withdrew our recommendation of this investment in January of 2009.

However, as all good money managers do, the principals of Hg Capital monitored their trading model during this period of extreme volatility and found that the lack of a cash option definitely contributed to the depth and severity of the drawdown that occurred in 2008.  After considerable research and testing, they implemented a cash position in the model, as well as other changes to enhance the model’s ability to manage crisis market conditions.

In mid-2009, we reviewed the changes made by Hg Capital and the corresponding improvement in performance.  At that time, we became comfortable that the changes implemented by Hg’s principals were effective in reducing the risks when market volatility was high and we reinstated our recommendation.

While Hg’s principals feel that the enhancements to their model should keep drawdowns from approaching the -25% level in the future, there is no guarantee that they will do so.  Hg Capital co-founder Byron Haven points out that the road to the 60%+ return in 2009 was punctuated by at least four drawdowns of 7% along the way, which indicates that this strategy is still an aggressive approach to trading the 30-year Treasury bond.

For investors with an appetite for aggressive investments that can trade long and short on a partial leveraged basis, this program may be just what you’re looking for.  Small allocations to this strategy can provide additional diversification to both aggressive investors and moderate risk investors who want to include an aggressive allocation in their portfolios.  

Administration

Hg’s LSGB program is traded at Rydex Funds using mutual funds that seek to provide daily long and short returns based on the price movements of the current Treasury long bond. The Government Long Bond 1.2X Strategy offers a 120% leveraged long exposure, while the Inverse Government Long Bond Strategy provides an unleveraged short exposure.

The LSGB Program is available to both taxable, IRA and other tax-qualified accounts.  Since this program trades frequently it will likely be subject to “wash sale” rules and short-term gains (or losses).  Thus, it may be most suitable for IRAs and other tax-qualified retirement accounts, including no-load, low-cost variable annuity products that may also help to negate the tax consequences of frequent trading in a non-retirement account.

The minimum account size for the Hg Capital LSGB Program is $25,000. Management fees are deducted quarterly in advance, based on the following schedule:

First $500,000

2.50% annually

$500,001 to $1 million

2.25% (entire account)

Over $1 million

2.00% (entire account)

(*Note that all of the above performance figures are quoted net of all management fees.)

Non-correlation is the Key to Diversification

As I have previously noted, the Hg Capital LSGB Program seeks capital gains from frequent trading of long bond index mutual funds based on the movement of interest rates.  With that being the case, 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.  As I discussed above, one answer is that Fed actions and global uncertainty could result in “tradable trends” in the long-term Treasury bond.  Tradable trends are price movements of sufficient size and duration to be identified by Hg’s trading model as potential opportunities to produce capital gains.

Another answer is that the potential for capital gains in the long bond, 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 both equity and bond indexes.  By correlation, I mean the tendency of an investment to go up or down in relation to other investments.

If two investments go up and down together, they are said to be positively correlated.  If one goes up when the other goes down, and vice versa, they are said to be negatively correlated.  However, if an investment’s gains or losses are independent of others, then it is said to be non-correlated.  Non-correlated investments are often preferred because they have the potential for gain or loss without respect to how any other investment in the portfolio may perform.

The chart below illustrates this relationship.  It shows the extent to which Hg Capital’s LSGB Program’s performance is correlated to major market indexes and other investment programs my firm offers.  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 0.097
Barclays Long-Term Treasury Index 0.104
   
Other Investment Programs
We Recommend: *
 
   
Columbus High-Yield Bond 0.156
Niemann Equity Plus 0.122
Niemann Risk Managed 0.130
Potomac Guardian 0.163
Scotia Growth S&P Plus 0.046
Scotia S&P Moderate Growth 0.014
Select Advisors Conservative 0.053
Select Advisors Moderate 0.027
Third Day Aggressive 0.009
Third Day S&P Plan 0.000
Wellesley Convertible Bond 0.116

The above R-Squared correlation analysis covers a period of time from the inception of the Hg LSGB Program in December 2004 through January 31, 2010.   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.

*  For more information on any of our other recommended investment programs, give us a call at 800-348-3601 or click this link to go to the Halbert Wealth Management website.

As you see from the table above, the LSGB Program has had virtually no correlation with the major stock market indexes in the past.  It even goes one better by having a low historical correlation to the Barclays Long-Term Treasury Bond index, which is closer to what a buy-and-hold position in Treasury bonds would return.  Best of all, the LSGB Program has had virtually no historical correlation to any of the existing AdvisorLink® actively managed investment programs.

What does this mean to you?  It means that you can construct a portfolio of actively managed investment programs that may perform independently from each other over time.  If the LSGB Program continues to perform as it has in the past, it could provide an additional degree of risk management to virtually any portfolio. 

Conclusion - Not For the Weak or Faint of Heart

I think 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.  While there are no guarantees, 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.

However, it 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 and leverage is employed. 

I encourage you to check out Hg Capital Advisor’s Long/Short Government Bond Program and see if it fits with your other investments. However, before investing in the LSGB Program, you should review your financial goals and other investments in your portfolio in order to determine if it is in line with your overall risk tolerance. 

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 our online request form

Wishing you profits,

Gary D. Halbert

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.   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. 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.  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 Barclays Long U.S. Treasury Indexrepresent 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 Hg Capital Long/Short Government Bond trading program since they are unmanaged Indexes which cannot be invested in directly.  The performance of the S & P 500 Stock Index and the Barclays Long U.S. Treasury Index is not meant to imply that investors should consider an investment in the Hg Capital Long/Short Government Bond trading program, which is actively managed, as comparable to an investment in the “blue chip” stocks that comprise the S & P 500 Stock Index or the US Treasury securities with a remaining maturity of 10 plus years that comprise the Barclays Long U.S. Treasury Index.

Historical performance data from 2007 to present represents the composite returns of representative accounts managed by Purcell, called the Purcell Dynamic US Government Bond.  It reflects the reinvestment of dividends and other earnings, and is net of all transaction, custodial and Purcell’s maximum management fee of 2.50%. Performance prior to 2007 represents an actual account in a program named Hg Capital 199Hg-TYX, custodied at Rydex Series Trust, and verified by Theta Investment Research, LLC.  These results reflect actual trades in a proprietary account of the Advisor, managed to mimic the Advisor’s trading signals.  The results may not reflect the performance of actual client accounts due to contributions and withdrawals from client accounts, tax loss sales, client-imposed investment restrictions and other factors. These performance numbers have not been verified by HWM, and therefore HWM is not responsible for their accuracy. Since all accounts in the program are managed similarly, the results shown are representative of the majority of participants in the Program.  The Program’s objective is to capitalize on the up and down movements in the price of the 30-year Treasury bond. 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.  Management fees are deducted from the account on a quarterly basis, and are not accrued monthly. They do not include the effect of annual IRA fees or mutual fund sales charges, if applicable. Dividends and capital gains have been reinvested. No adjustment has been made for income tax liability.  Consult your tax advisor.  “Annualized” returns take into account compounding of earnings over the course of an investment’s track record. 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.


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Forecasts & Trends E-Letter is published by Halbert Wealth Management, Inc. Gary D. Halbert is the president and CEO of Halbert Wealth Management, 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, Halbert Wealth Management, 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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