4.2.2019 Tommi Kemppainen

2018: the First Year of Falling Markets

How do you plan to avoid losses in a recession?

The majority of the world’s stock markets fell during 2018. The value of HCP Black also fell by 3.36%, and there is nothing to celebrate about it.

For comparison, however, let’s take a look at a global stock market index, the MSCI ACWI IMI, which fell nearly 9% in euros. Compared to this, the decline of Black by 3.36 % is relatively small. This means that the fund was fairly immune to the global falling trend. In addition, the volatility of the fund remained at just over four percent, which shows that it succeeded in diversifying the risk. Had the market decline been bigger and sharper than this, it’s probable that the fund’s return would have risen considerably on the plus side. The reason is that HCP Black currently mainly invests in asset classes other than stocks and bonds.

One year of declining market

The figure shows the one-year return on the global stock market on 24/1/2019. Total returns calculated in USD. Source: https://www.msci.com/countries-heat-map

The return of insurance-linked strategies does not depend on economic cycles

Last year, HCP Black’s largest investment with a 35% allocation was in insurance-linked securities, which carry the risk of large-scale natural disasters, typically in annual contracts. The return and risk of this strategy are not dependent on the economic cycles, but on whether major natural disasters occur during the year of the contract.

In typical years, these premiums can generate approximately a 4% annual return. In those years when major natural disasters like hurricanes take place, the insurance strategy generates loss. The years 2017 and 2018 made up the worst two-year period as regards actualized risk. In 2018, we were left with −1.3% with this strategy.

However, our choice of security within this asset class was excellent because some securities that were on offer fell as much as 60%. When investing in such atypical asset classes, it is justifiable to pay for the selection of securities if you don’t intend to spend a lot of time on the process yourself. Because the devil is in the detail. It is this work, for example, that you pay for as a unitholder.

The trend following strategy benefits from trends in financial prices

The second largest allocation in HCP Black, with about 25% of investments, was a strategy called trend following, which aims at benefitting from the market trends of over one hundred different financial prices. In typical years, trend following generates some profit, but last year this investment block made a loss of 2.4%.

If the market fall that began on Jan 26, 2018, continues and accelerates in 2019, this investment is likely to perform well. Trend following is an exceptional investment strategy for the combination of two reasons. Firstly, in a typical year, it generates some profit. Secondly, during stock market crashes, it is justifiable to expect it to generate significant profits because financial crises typically have strong trend-like movement. This investment category is further explained in this review of trends over the last 100 years, for example.

Stocks offer the highest earning potential

HCP Black has invested in stocks through the funds HCP Quant and HCP Focus. I would like to remind you that HCP Black does not pay a management fee, neither fixed nor performance-based, for these investments. Within this allocation, HCP Focus generated a marginal 0.12% profit while HCP Quant made a loss of 2.5%.

Despite the risks, it is justifiable to own stocks. For example, HCP Focus includes companies whose market value after 20 years could be nearer 100-fold than 10-fold compared to their current value. Focus invests in companies that benefit from network effects, such as peer-to-peer lending platforms. Such platforms are now a dime a dozen, but the one that first gains a critical mass of users may grow exponentially.

HCP Quant doesn’t have such exponential growth potential. Quant chooses companies that are so undervalued that they are annually subject to buyouts from the stock exchange at a price higher than the market price. This deep value theme of HCP Quant has been unpopular in the market for nearly a decade, which means that it has not performed well.

However, if western countries face a fate similar to that of Japan, where the size of the workforce decreases due to the aging of the population and where economic growth is revived by increasing the amount of debt, such companies that Quant invests in are the most likely stock market risers.

Real estate investments secure the purchasing power of money

HCP Black’s investments worldwide in real estate and in the Japanese real estate market yielded returns of −0.6% and +0.2%. Real estate as an asset class plays an important role in maintaining the purchasing power of money in the current economic situation. A short, less than a ten-year economic cycle already shows signs of slowing down. Also, a longer 80-year cycle of debt growth seems to have come to an end. In the first quarter of this year, the increase in the size of central bank balance sheets will change into contraction.

The economic history is full of chains of events where an aggressive increase of the amount of money has weakened people’s trust in the ability of money to maintain its purchasing power. This is when retaining the purchasing power has required investments in alternative investments like real estate.

You can read more about different real estate investment themes in my writing Home in Homeland – Real Estate Investments Globally.

The right choice of security is the key also regarding this investment block. In my opinion, the best tactic is to buy in a property market that has already crashed (cf. Finland in 1992) in order to maximize the expected return relative to the risk. “The devil is in the detail” is a valid idiom also regarding the real estate market.

Gold, life insurance and currencies

Investments in gold and life insurance aftermarket yielded returns of 0.2% and 0.7% to HCP Black. From currency investments, the US dollar, the Japanese yen and the Swiss franc strengthened. These currencies are classics that have been safe havens in world turmoil. The same is true for gold – especially when the challenge has been about an excessive amount of debt.

The life insurance aftermarkets are not cyclical, and investments in them should not suffer even in a poor economic situation. This is one way of managing risks in 2019.

It should also be noted that the return of 2018 was reduced by one percent by the tail hedge, which is paid-for protection. Under normal circumstances, diversification of investments should be a sufficient tool for a fund’s risk management. However, now that the 80-year debt cycle seems to have come to an end and the risk of a market crash is exceptionally high, I think it’s justified to pay to reduce extreme risk. This has been handled by purchasing rights for a limited period to sell securities at a predetermined price. The value of the rights increases as the prices of the securities fall. As a rough estimate, this hedging can bring a 10% return to the fund in a typical stock market crash, and the return can be even larger if the market crash is bigger and steeper. But the loss is never more than one percent.

HCP Black protects against market fluctuations

For many of our customers, HCP Black functions as a tool for risk diversification. It is an investment whose value is mainly based on prices other than those of stocks and bonds. HCP Group’s own investable recession buffer, which is roughly a million euros when writing this, is also invested in the HCP Black fund.

In this review, there is nothing new to report on the global stock market valuation levels and the historically high over-indebtedness in the world. You can read the background and gain some perspective from my writing How Much is a Lot of Debt?

Looking ahead, HCP Black’s strategy is the best way I know how to invest right now when there’s anxiety about a recession, depression and the end of the long debt cycle. This is why we use the fund ourselves.

During 2018, the over-indebtedness of the world began to unravel, which was reflected in the decreased value of many risky assets. The same development can be expected to continue also in 2019. The world’s central banks are likely to follow the American model and reduce their balance sheets – just as they increased their balance sheets the American way when quantitative easing began with the latest global financial crisis.

As I write this, the market has fallen for a year already, and market volatility has increased. To my best understanding, current events are very similar to the previous debt-driven events in the world.

If two years ago I had guessed the state of the stock market – after a year of America’s quantitative tightening, and when for the first time in the world’s economic history the balance sheets of all central banks are decreasing – I would have guessed the market to have fallen by 50% instead of a few percent. So it is surprising how slowly and unwillingly the market is now pricing current or future events.

As I stated at the beginning of 2018, this is “the beginning of the end of this new era of quantitative easing”.

As for 2019, this quantitative tightening can be expected to continue.

It is especially important to understand the effects of this quantitative tightening.

If you are primarily concerned with maintaining purchasing power, HCP Black is, according to my best understanding, positioned just right. You can always follow my market observations via the @hcpgroup Twitter account.

How do you plan to avoid losses in a recession?

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