FORECASTS & TRENDS E-LETTER
Gary D. Halbert
October 2, 2007

IN THIS ISSUE:

1.   The Economy – Slowdown Or Recession?

2.   What’s Up (Or Down) With Bonds?

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

4.   Performance Evaluation

5.   Is This Program Right For You?

Introduction

This week I am pleased to introduce you to the latest Registered Investment Advisor to make it onto our recommended list.  For years, we have looked for an active money manager that specialized in Treasury bonds, but good ones are few and far between.  So we were particularly excited to find Hg Capital Advisors who has a program that trades US Treasury bond mutual funds, both long and short.  In the pages that follow, I will tell you all about Hg’s bond program, how it works and of course, their actual performance record (prepare to be impressed).

But first, we need to review some recent economic data which are not encouraging.  Several key reports have been released over the last 2-3 weeks which suggest that the odds of a recession have increased.  The Bank Credit Analyst continues to believe that a recession is not the most likely scenario over the next 6-12 months, and they may yet be correct.  However, as I will discuss below, economic conditions have deteriorated over the last couple of months.

At the least, we can say with certainty that the US economy is slowing down, and only time will tell if it slows to the point of a mild recession.  Historically, economic slowdowns and recessions have been bullish for bonds, and it is true that bond yields fell significantly over the summer, helped in part by a huge “flight to safety.”  But for most of September, bond yields rose rather significantly, even though most economic reports last month were negative. 

As I will discuss below, the bond market has been in a broad trading range for the last two years, and unless we’re headed into a serious recession, which I doubt, this broad trading range in bonds may very well continue.  Whatever the case may be, I believe this may be a good time to invest with the professionals at Hg Capital Advisors, with their long and short strategy, and let them manage your allocation to Treasury bonds, provided such an investment is suitable for you in light of your financial situation.

The Economy – Slowdown Or Recession?

Certainly not all the economic news of late has been bad.  The latest inflation numbers were tame, and this influenced Bernanke & Company to cut not only the Fed Funds rate by 50 basis points, but also the Discount rate by 50 bips on September 18.  Stocks soared for a few days.  And why not?  Most of the economic reports we got in August were encouraging, so why not have a party after the Fed rate cut?

Yet several reports over the last 2-3 weeks look quite concerning.  Let’s run through the numbers.  The government released the final report on 2Q GDP, reducing it from 4.0% annual growth to 3.8% - that’s still a strong number.  On the negative side, the Index of Leading Economic Indicators was sharply lower in August, down 0.6% - that’s a sizable drop.  Orders for durable goods fell 4.9% in August.  And consumer confidence continued to fall sharply in September.  These are not good signs.

Of course the housing numbers all continue to worsen.  Sales of new and existing homes fell again in August, as did housing starts and new building permits.  Pending home sales plunged 12.2% in July (latest data available) as more and more mortgages are falling through prior to closing.  The continued weakness in the housing numbers is not surprising.

So is this just the slowdown that BCA has been predicting all year, or are we headed for a recession?  While the latest economic reports are of serious concern, I would not predict a recession based on only one month’s worth of data.  Consumers will ultimately decide if we’re going to have a recession or not.  Fortunately, the Commerce Dept. reported last Friday that personal spending actually increased 0.6% in August, which was better than expected. 

And the holiday spending season is upon us, which further supports my view that we will not see a recession this year.  But in the meantime, we are definitely in an economic slowdown that is likely to last for at least the next several months.

What’s Up (Or Down) With Bonds?

As the subprime and related mortgage fiasco played out over the summer, there was a huge flight to safety.  Investors in droves unloaded riskier assets for the safety of US Treasuries.  This occurred as the economy was slowing down from the near 4% growth (annual rate) in the 2Q.  Both factors served to drive interest rates lower.  At one point, the yield on the 30-year Treasury bond fell to below 5% in September. 

As noted above, if the economy is slowing down, which it clearly is, that should be good news for bonds, and interest rates should be moving lower.  Yet in September, bond prices spiked lower and rates went higher.  So what gives?  Some argue that the latest rate cut by the Fed is a sign that they’ve taken their eye off of inflation.  Perhaps that’s part of the reason bond yields went higher recently.  But if we look at the chart below, we can see that the bond market has been mostly in a trading range for the last two years.

Unless we are headed for a serious recession, it will not surprise me if the bond market remains in a broad trading range for some time to come, torn between an economy that is slowing down and continued inflation fears whenever the Fed cuts rates.  If that continues to be the case, then a buy-and-hold strategy in bonds may do well just to break even in the months ahead, or may even lose money.

This is precisely why I hope you read on as I introduce you to the newest money manager to make it onto our recommended list – Hg Capital Advisors.

Introducing The Long/Short Government Bond Program

As I noted above, since the inception of our AdvisorLink® program in 1995, we have searched for a strategy that actively manages Treasury bonds, and especially the 30-year T-bond – also known as the “long bond.”  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.  While we have found a number of candidates over the years, it seemed that their programs were either all based on back-testing (which we equate to fairy tales), or could never stand the test of time.  That is, UNTIL NOW!

I am very pleased to introduce you to Hg Capital Advisors and their Long/Short Government Bond (LSGB) Program.  This 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 long bond. 

The LSGB Program provides an actively managed Treasury bond strategy that has also outpaced both the S&P 500 and the Lehman Long Government Bond Indexes since its inception.  While past performance is no guarantee of future success, we feel that the LSGB’s average annualized return of over 20%, coupled with a month-end drawdown of less than -9%, may deserve your consideration.  Be sure to refer to additional important disclosure information at the end of this E-Letter.

Hg Capital Advisors Background

The principals of Hg Capital Advisors are Byron Haven, Ted Lundgren and Dennis Shaw.  Each of these three individuals contributes different disciplines and skill sets, bringing about a synergy of sorts in the development of their computerized trading model.  Together, they have developed, tested and operated a 100% mechanical model for trading the 30-year Treasury bond on a long or short basis.

The background of each of the principals, and how they came together as a team, is an interesting story.  Byron, while obtaining a degree in chemistry, took a job with Occidental Research as a chemist.  It was there that he first met Dennis, who was also working as a chemist, but later found his calling in computer science.

While they worked together, Dennis purchased 100 shares of Occidental Petroleum stock, and then later sold it at a substantial profit.  When he told Byron about this, it set in motion a multi-year fascination with stocks on Byron’s part.  Byron later took a job with Chevron, and transferred to Houston in 1988.  By that time, however, he already had his securities license and was working in the brokerage business part-time.

Byron eventually took an early retirement offer from Chevron in 1992, and then focused his full attention on his brokerage business, concentrating on small-cap growth stocks.

While Byron and Dennis were charting their courses with Occidental Petroleum and later Chevron, Ted Lundgren was working in a different direction.  Graduating from college with a degree in economics and East Asian cultures, he initially worked for a communications company in Indiana. 

In 1991, Ted decided to make a move both geographically and career-wise.  He moved to Houston and took a job as a broker with a major national brokerage firm.  He had always been interested in stocks, and working on the brokerage side would allow him to see economics in action.

In 1994, Ted and Byron were introduced to each other, and began an informal working relationship.  By 1999, they were sharing office space, but still pretty much pursuing their own separate businesses.  It was not until they both attended a seminar on the advantages of active asset management and minimizing risk that the seeds of a new working relationship were sewn.

They began developing a way to manage money based on a statistical analysis of historical market activity.  At that time, they were fortunate to get the attention of another individual who became a silent partner, and funded the operation so that Byron and Ted could concentrate on perfecting their model.  They formed Hg Capital Advisors in 2001, and began the task of developing their trading models.  (The silent partner still owns a small share in the business, but plays no active part in its money management activities.)

As they continued to develop their computerized models, it soon became apparent that computer hardware and software constraints were going to impede further progress.  It was at that time that they sought out Byron’s old friend Dennis Shaw, who joined Hg in 2003 and contributed needed systems expertise as well as mathematical discipline.

The team was complete, and over the next couple of years, both bond and equity trading models were perfected.  In late 2004, Hg started trading actual money in the programs, and by the time they hit two years of actual track record, their performance began drawing the attention of investors across the country.  Not surprisingly, Hg has gone from virtual obscurity in 2004 to managing over $45 million for hundreds of clients across the country today.

The Long/Short Government Bond Trading Model

Hg Capital’s bond and equity trading models are both based on a similar approach.  Hg has identified a number of what they call “rules” and have incorporated them 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.”

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.

An example of one of these rules is that, statistically speaking, if the market goes up on one day, it should also go up the next day.  While this is obviously over simplistic, it illustrates the kinds of observations that are incorporated into their statistical analysis.  However, Hg stresses that their rules are not developed by optimizing or “curve fitting” to historical data, since optimized models often fail to produce favorable ongoing results.

Additional rules are added by agreement among Byron, Ted and Dennis.  Once a rule has been incorporated into the system, it can never be taken out again.  Byron says this would amount to “cherry picking” the rules.  Instead, it stays within the system even though it may never be a determining factor as to an actual long or short trade.

The primary emphasis of the bond model is an analysis of interest rate data.  Since interest rates generally move in more gradual ups and downs than the stock markets, the bond methodology is somewhat simpler than their equity system.  Also, while the equity system considers each rule independently, the bond system does consider the interdependence of some of its rules in order to reach a trading signal.  In the bond program, accounts are either long or short, and are never in cash.

It is important to note that the Hg Capital 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.  Ted made the statement that if they happen 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.  Their own statistical analysis indicates that their systems are right approximately 58% to 60% of the time, based on daily data.  Our month-end performance analysis shows the bond program has a positive monthly return approximately 70% 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.  They also stress that the worst historical month-end drawdown of -8.8% may understate the downside risk of this program.

Performance Evaluation

You will note that the Hg Capital LSGB Program has a much shorter track record than is usually found in our AdvisorLink® program.  As a general rule, we require a program to have a minimum three full years of actual track record to be recommended.  However, because of the extensive development process employed by Hg Capital, we feel comfortable recommending this program to our aggressive clients.

The detailed performance information below shows that the LSGB Program compares very well to equity and bond benchmarks, both on an inception-to-date and year-to-date basis.  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 estimated average annualized return of 20.17% as of the end of September, net of all fees and expenses.  The worst-ever losing period (or “drawdown”) was –8.76%, which occurred during the recent subprime meltdown.

See the actual performance history in the tables below for more 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 very 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. 

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.

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 to other Advisors in our AdvisorLink® program.

Since Byron, Ted and Dennis are all familiar with the details of the model, they provide an ample level of redundancy so that the model could continue to be run or existing trades unwound if anything were to happen to any one of them. Purcell also serves as an extra measure of backup so that trades could be unwound if anything were to happen to all three Hg principals.

The LSGB Program is available to both taxable, IRA and other tax-qualified accounts.  Since this program trades frequently it may 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 available through Purcell 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 $50,000. Management fees are billed quarterly in advance, based on the following schedule:

Correlation Is The Key

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.  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 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 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 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.

As you see from the chart, the LSGB Program has had virtually no correlation with the major stock market indexes in the past.  It even goes one better by not having a high historical correlation to the Lehman Long Bond index, which is what a buy-and-hold position in the long bond 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 a degree of risk management to virtually any portfolio.  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.

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.  It 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.  As I noted at the beginning of this article, 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 120%.  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.

I encourage you to check out Hg Capital Advisor’s Long/Short Government Bond Program and see how 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 that, as a whole, your investment portfolio is not out of sync with your 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. 

Wishing you profits,

Gary D. Halbert

SPECIAL ARTICLES

Clarence Thomas' Great American Story
http://www.realclearpolitics.com/articles/2007/10/clarence_thomass_great_america.html

MoveOn Ad Raises Cash For The GOP
http://www.washingtontimes.com/article/20071001/NATION/110010061/1001

Understanding the "SCHIP" controversy (good read).
http://www.msnbc.msn.com/id/21047607/site/newsweek/page/0/

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 Lehman Long Government Bond Index 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 Lehman Long Government Bond Index 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 Lehman Long Government Bond Index. 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) Hg Capital 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.

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