The difficulty lies not so much in developing new ideas as in escaping from old ones.
John Maynard Keynes
Our insights, reflections and musings on the most timely topics relevant to managing your investments.
The market is back. It has certainly been a crazy ride thus far this year. In the aftermath of the recent downturn we have learned more about what caused it, or at least what made it as sharp and quick of a downturn.
After a huge year in 2017, the market took off like a rocket in January. Now that rocket is coming back to earth. Had I told any of our clients that in early February that the market basically would be flat for the year, I believe most would have taken that as good news, considering…
2018 is off to a fast start. We actually got tax reform to end 2017, and the University of Georgia Bulldogs made it to the National Championship game for college football. Is it any surprise that much of the nation is feeling like hell must have frozen over? Well, Alabama took care of business and…
Have you seen Disney’s “Prep and Landing” children’s Christmas specials? They are worth the watch. The premise is that Santa is assisted with his Christmas Eve duties by an elite team of elves who prepare each house for the big man’s arrival. Naughty children, however, are visited by another group of elves, the Coal Brigade….
This rally just will not end. It has changed character several times, with different segments of the market taking the lead. It has had slight pauses that might signal an oncoming market correction, but through it all this market just keeps climbing. The recent leadership has come from China. Emerging markets have been the best…
The market is back. It has certainly been a crazy ride thus far this year. We start up more than 8 percent, then drop 10 percent, and now we are riding back up. A 10 percent correction is normal in long bull markets, but how this one happened was not.
In the aftermath of the recent downturn we have learned more about what caused it, or at least what made it as sharp and quick of a downturn. Many hedge funds that are primarily being run by computers were borrowing money to purchase so-called inverse exchange traded products tracking the VIX, a volatility index sponsored by the Chicago Board Options Exchange (CBOE). These products supposedly produce the inverse, or opposite, return of the index. So if the VIX is up 10 percent, then these products go down 10 percent. Several of these products are leveraged, meaning they will track two or more times the index return. So if the VIX is up 10 percent, these products will be down 20 percent or more.
There are so many things wrong with this it is hard to know where to start. The first issue is the issue of ETF investing in the first place. The first ETFs were based on the S&P 500 index; they are basically index funds, which can be bought and sold any time during the day, as opposed to index mutual funds that can only be bought and sold at market close. Their original purpose was to give institutional investors a place to temporarily park money while transitioning a portfolio from one money manager to another.
Wall Street quickly learned other uses, and like almost every financial crisis in history will prove, bad things happen when Wall Street starts using products for uses other than for what they were originally intended. All kinds of investors started using ETFs, and of course Wall Street started filling that demand with every imaginable flavor. The problem is, most of these products don’t actually work. It is pretty easy to track an index like the S&P 500 – just buy the 500 stocks represented. These are among the largest companies in the world and the market for their stocks is robust so they are easily bought and sold at a moment’s notice.
The further one wanders away from the S&P 500, however, the less true that becomes. Smaller companies’ stocks do not always trade frequently, and it may be hard to buy or sell on demand. The funds that try to track these indexes may not be able to buy all the stocks in the index the moment an investor wishes to buy the ETF. Likewise they may not be able to sell. The problem gets worse for fixed income or bond-related products. Remember, bonds are just loans. A company or a government that needs to borrow money will issue bonds. They only issue the number of bonds they actually need. ETFs and other products tracking bond indexes are often not able to buy the actual bonds, so they buy so-called derivative securities that will hopefully track the index.
The VIX is another problem altogether, because it isn’t real. There is nothing to buy. It is an arbitrary measure of options activity, which the CBOE claims is a good approximation of overall market volatility. Investors buy options to protect against losses in underlying securities. If more people are buying options, then the logic states that they are more worried about loss and therefore experiencing more volatility. In other words, the VIX is more akin to placing a bet on the over/under of a sporting event than it is to an investment. Gamblers – which I’m going to call them, because that is what they really are – develop wagers in the form of derivative products that track the VIX. The ETFs then “invest” in these derivatives. If that makes no sense to you, then welcome to the club.
The final problem with all the ETF-type products is perhaps easier to understand. Index investing is supposed to be passive: just buy the entire market and hold it for a long time. That is the entire theory. However, that is not how people are using these products. A passive investor has no reason to be able to trade whenever he or she wishes because he or she is, by definition, not a trader. These products are being used to trade into and out of stocks faster than ever before in history. The ripple effects mean that prices move more than ever, even when the VIX says volatility is low.
The first fundamental rule of prudent investing is that it is done from the bottom-up. Stock is simply ownership in a company. Investors are investing in companies, not trading pieces of paper. Companies are real; they have real products and services and real revenues and earnings. They have value, and that value adds safety to your investment.
There once was a day when the investment advisory industry was a professional service, helping clients invest for their future. It still is that way at Iron Capital. We will let others buy products, exchange-traded and otherwise. We will stick to investing in things that are real.
~Invest in What Is Real
After a huge year in 2017, the market took off like a rocket in January. Now that rocket is coming back to earth. Had I told any of our clients that in early February that the market basically would be flat for the year, I believe most would have taken that as good news, considering the year we had in 2017. However, it doesn’t feel that way when we go straight up then come straight back down.
I have said this many times, and likely will say it many more times: Those who trade in markets must be terrified. Fortunately for our readers, that is not what we do. We invest in companies. So how are companies doing?
JP Morgan reported Monday morning that revenue growth for S&P 500 companies is growing at 8.38 percent. They expect 20 percent earnings growth for the quarter. FactSet, an investment data service, tells us that half of companies have reported their fourth quarter 2017 results, of which 75 percent had better earnings than expected, and 80 percent had better revenues than expected. If that 80 percent number holds, then that would be a new record. We don’t hear much about those records, though.
Of course, if companies are doing well, it means that the consumers who buy their goods are doing well. That means the economy is doing well. In fact, all the economic data has been good – too good, according to the short-term speculators who are driving this dip. The economy is so good that interest rates will rise and the Fed will put a kibosh on the stock market party. There is just one problem with that theory.
Stocks, over the long haul, rise with interest rates. Higher interest rates mean stronger economic activity. Like everything which is driven by the masses, markets tend to overdo things. It is when interest rates peak that stocks tend to fall. We are a long way from that point. This is not the beginning of a bear market.
Stocks do not go up in straight lines. We have been saying that a correction was in order for some time now, and that when it happened it would actually be a positive thing for the longer haul. Well, now it is happening. It may continue for a short time, or it could be over tomorrow. That is why trading in markets is, in our opinion, a fool’s errand.
How do we cope with this volatility? By knowing what we own and why we own it. That can be harder than it used to be as the day traders have been replaced by computers. The computers create short-term moves that are just ridiculous. It becomes hard to keep in mind that short-term moves are exactly that.
What matters in the long haul is: how are the companies doing that I actually own? By keeping focused on this, prudent investors can not only avoid the emotional mistakes that come from focusing on daily or even intra-daily movements and instead use volatility as an opportunity. This is not a time for panic. It is a time for shopping for opportunities.
Chuck Osborne, CFA
~It Goes Both Ways?
2018 is off to a fast start. We actually got tax reform to end 2017, and the University of Georgia Bulldogs made it to the National Championship game for college football. Is it any surprise that much of the nation is feeling like hell must have frozen over?
Well, Alabama took care of business and the temperatures are moderating once again. After all, we may celebrate new beginnings every January 1, but in reality, it is just another day. Of course one would not know it if she listens to the commercials for “Wealth Managers” or watches CNBC.
Every January we go through this ritual of wrapping up the previous year and then debating what new strategy we need for the upcoming year. But why? First of all, January 1 is not all that different from December 31. Secondly, if a change is needed then it is needed when it is needed, not at some random moment on the calendar.
Imagine what would have happened if Alabama’s coach, Nick Saban, had waited until next football season to change his quarterback and his game plan? UGA would be national champions. If a change is needed then it is needed now; if it is not, well then don’t fix what isn’t broken.
We have been doing this so long at Iron Capital and our clients are so loyal that I sometimes forget to remind folks what it is that makes us different. Wall Street celebrates milestones like the New Year because they are in a transaction business. They want investors to change strategies as often as possible because that means transactions, and transactions mean revenue. At Iron Capital we are in the relationship business and we make more money when your portfolio grows, not by more transactions.
The traditional financial adviser is trained as a salesperson. They spend their days servicing existing clients and prospecting for new ones. They do not spend their days reviewing every investment that their clients own and deciding if they are still appropriate. They look at the client’s portfolio when it is review time, and guess what: a change of some sort will be in order.
Will 2018 be different than 2017? There is no doubt it will; no two years are exactly alike. But, is January all that different from December? Not so much.
So what will 2018 bring in the market? In all likelihood it will be more of the same. The economy is moving ahead strongly, not just here but also globally. The stocks of international companies are still far behind their American counterparts in terms of returns, and that gap will likely continue to close. Small companies who cannot afford expensive lobbyists will likely benefit more from tax reform than large companies who benefited from loopholes. Interest rates should rise as the economy improves, but they remain low. In other words, the world did not chance substantively on January 1, and neither should your portfolio.
Nothing goes up in a straight line and it would not be surprising to see the market experience a mild correction. We would see that as an opportunity, not something to fear. If something changes then so will we, not next season but during this game. That is what makes us who we are.
2017 was a good year for our clients and 2018 is off to a great start. For all of our Alabama friends, Roll Tide, and for the rest of us, well it’s a new year!
~New Year, New Market?
Have you seen Disney’s “Prep and Landing” children’s Christmas specials? They are worth the watch. The premise is that Santa is assisted with his Christmas Eve duties by an elite team of elves who prepare each house for the big man’s arrival. Naughty children, however, are visited by another group of elves, the Coal Brigade. They get coal in the stocking with a note which says, “Try harder next year.”
So what about us? Did we just get coal in our stocking or is that a diamond? Tax reform is finally here and the Republicans have their victory, but what does that mean for us? It means that the vast majority of Americans will pay less in taxes. Beyond that, no one really knows and anyone who says they do is selling something.
I have a Bachelor of Arts degree in Economics from Wake Forest University, and maybe I am just getting more nostalgic as I age, but I miss the days when economics was more of an art and less of a science. Here is what we actually know about taxes and economic activity: We know that when you tax the private sector – individuals and companies – you take money away from the productive force in our economy and give it to the government. Government is necessary, and there are many legitimate roles of government, but government does not create productivity and growth. Government takes what is already there and redistributes it.
I hear the naysayers now, “What do you mean government does not create productivity? They build roads, etc.” This is true; providing a community-wide infrastructure is an important and legitimate role of government. But, government does not create the need for the road. We need roads because we live here and work there. It is our activity that creates the need for infrastructure and since it is a shared need, it is best fulfilled cooperatively through democratic government. It doesn’t have to be that way; as anyone who has ever been stuck in traffic in Atlanta knows, not all city streets are planned. The horses decided where the infamous Peachtree Street would meander, as they traveled the safest route along the ridge. If any visitors to Atlanta doubt Peachtree is actually a ridge I would encourage you to get out of your hotel and take a jog. (While I am on the subject, of course you can drive in the snow in Chicago; Chicago is flat and the streets are in a grid…)
I digress. It is often useful to think of the economy as a pie. One can slice it up many ways, but for our illustration we have just two slices, the private sector and the government. All growth comes from the private sector, so the bigger it is relative to the government, the more economic growth we have. Government is necessary and can only be funded by taxation. The ideal tax system is one with low rates and no loopholes. That is unfortunately politically impossible. This current reform does, however, move us in that direction, and is therefore a good thing on the whole.
I don’t expect Democrats to admit that, because it is a Republican bill. Even though corporate tax reform was on the Obama agenda. This, in theory, is something everyone agrees on, but the Republicans refused to give Obama a “victory” when he was in office, and now the Democrats refuse to go along. It is disappointing, but unfortunately not surprising. This is the state of our politics. Nothing is about policy anymore; it is all about us vs. them. We have unfortunately come to expect that from our politicians.
The sad thing is that we now seem to have this same dynamic within our supposedly non-partisan policy experts. Facts are cherry-picked to fit the pre-determined narrative, and projections that serve that narrative suddenly become fact. Projections are not fact. In fact, the only thing one can be certain of when projecting the future is that the projection will not be accurate. It might come close, but that is the best any fortune-teller can hope.
Will this tax bill add to deficits in the long-term? That depends. This bill will stimulate growth, this is certain; the unknowable question is, how much growth? The naysayers think it will add only a little to the economy and therefore it will be a net loss in tax revenue. The proponents say there will be substantial gains, and therefore the cuts will pay for themselves. The truth? Only time, not politicians or pundits, will tell.
In the meantime, enjoy a little bit more of your money, and have a very Merry Christmas!
Chuck Osborne, CFA
~What’s in Your Stocking?
This rally just will not end. It has changed character several times, with different segments of the market taking the lead. It has had slight pauses that might signal an oncoming market correction, but through it all this market just keeps climbing.
The recent leadership has come from China. Emerging markets have been the best place to be this year and Chinese technology companies have led the way. Can it last?
Yes, it can. Of course, there are never any guarantees in the financial markets and something can always go wrong, but this rally is mostly based on better company results, which means a better economy and ultimately a better consumer. We see it in the economic data and we also see it in real life.
This past Sunday was my son Charlie’s tenth birthday. For his birthday we gave him a trip, wherever he wanted to go – within reason and budget of course. He chose Disney World. Our flight to Orlando was packed; our hotel was completely full. The parks were wall-to-wall people, a large portion of whom were wearing matching t-shirts, and one brave man who won my affection by wearing a shirt which simply stated that no one was ever getting him into a matching t-shirt. Everyone must stand for something.
Perhaps the greatest signal of economic strength was found in the fact that on my son’s birthday some people – not the Osbornes – were willing to wait for 170+ minutes to ride the Seven Dwarfs Mine Train, the newest roller coaster in the Magic Kingdom.
Disney World is an interesting place. Some people absolutely love it and others absolutely hate it, but there is no doubt that it is an American landmark. I got to meet a sailor in our U.S. Navy who took his four kids to the park using tickets given to him through a military charity. It was a treat before he shipped off in a week’s time. I met a family with five sons, all adopted but no less brothers. I won’t lie, my family witnessed some rude behavior some from children but unfortunately much from parents. However, we witnessed a hundred small kindnesses as well. We witnessed the great diversity of our nation and our shared culture.
When one takes it all in he realizes that he has much for which to be thankful. In keeping with our tradition here is my list. This year I am thankful for:
~ A good year in the financial markets.
~ The United States of America, where people from all walks of life can share experiences like Disney World.
~ My children, whose enthusiasm for the small things in life reminds me of what is truly important.
~ My family, immediate and extended.
~ All of my friends.
~ As always, Mama’s pumpkin cheesecake and my loose-fitting pants which make enjoyment of said cheesecake possible.
~ Finally, for you, our clients and friends. Your trust in Iron Capital is our greatest asset and we value it every day of the year.
Chuck Osborne, CFA