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.
My kids just watched the Charlie Brown Halloween special, fall weather has finally arrived in Atlanta, and our front porch is full of various types of pumpkins. It is October. So, why is the market selling off? It is October, what other reason do we need? As we said when this selloff began, this is…
It’s a bird, it’s a plane…no, it’s interest rates! Rising interest rates do not kill bull markets; they actually go hand-in-hand. I know this is counter to what you have learned from every financial media outlet and the short-term traders who often sit at their desks, but it is true. In fact, it is “textbook,” as they say.
The big question for our economy is: How much of the good done by tax reform and regulatory relief is being undone by tariffs?
Different people see the world differently, and until you learn that, it can be difficult to communicate with someone who simply does not see what is so plain to see from your perspective. For me, it is connections. I see connections almost everywhere and sometimes I can grow impatient with people who don’t see it….
This market is becoming more and more fixated on trade and it is getting ahead of itself. The market, after all, does not reflect the present; it reflects the consensus of what the future will look like. When the trade talk started it reflected winners and losers; now in the past few days it has seemingly shifted to predicting that everyone will lose.
My kids just watched the Charlie Brown Halloween special, fall weather has finally arrived in Atlanta, and our front porch is full of various types of pumpkins. It is October.
So, why is the market selling off? It is October, what other reason do we need? As we said when this selloff began, this is a buying opportunity for long-term investors, and buying is pretty much what we have been doing. Slowly and carefully, but we are still positive because companies are for the most part doing well, and companies are the things in which we invest.
Of course, the talking heads have to have something to say, so they will search for reasons. Tensions with China, rising interest rates, the eventual end of our economic expansion – the news has mentioned all of these things, so let’s address them.
China does have real problems. Are they being caused by Trump’s policies? He will take credit, I am sure, but the truth is that it is impossible to know. What we do know is that their growth rate is slowing. Their stock market is down dramatically and they have currency problems as well. Is this impacting our markets? Perhaps, but thus far it has not actually impacted American companies. Earnings reports remain strong, and guidance for future earnings has remained strong. We invest in companies, not markets, so it appears we are good here.
Interest rates spiked suddenly and everyone began talking about them; this is what is causing the downturn. At least that is what many have said. The problem with this theory is that rising interest rates at this point in the economic cycle indicate better growth. It means people are more optimistic about the future and therefore demand a higher return on their money if they are to loan it to anyone. It also stopped; after the one-week spike, interest rates have leveled off. This does not seem a likely deterrent to company earnings unless a particular company has too much debt. That is easily avoided by us or the mutual fund managers we may use.
We are in year nine of our economic expansion and we have to be coming to the end, right? Wrong. It is true that the average economic cycle going back many years is approximately five years. The cycle means we have a recession (which is defined as at least two quarters in a row of negative economic growth), then we have a recovery. After the recovery, we expand and eventually have another recession. We cycle. Nine years is a long cycle; however, there is no evidence that cycles know what time it is or have a stopwatch. Cycles vary; some are short, some are long, and five years is an average. Cycles have also been getting longer. The other factor to consider is that this positive cycle started and for many years remained much slower than normal. Several years into the expansion, polls still indicated that people thought we were in a recession. I know there is a textbook definition, but perhaps one could argue that if most people think it feels like a recession, then it probably is a recession. If we look at the world that way, then this expansion is much younger than the experts claim. We have to be mindful of the data and willing to accept what it is telling us, but at this point there is no sign of recession ahead.
So, what is the reason? In the immortal words of Mr. Gibbs from “Pirates of the Caribbean,” “reason’s got nothin’ to do with it.” Prudent investors see market behavior like this as an opportunity. It isn’t that scary in October – it’s trick or treat time!
Chuck Osborne, CFA
~Boo! October Can Be Scary
Yesterday we were on our way home from a short family vacation when my wife looked over and informed me that the headline she had just received from the Wall Street Journal was, “Surging Yields Raise Threat of Tipping Point for Stocks.” I laughed.
If you are like my wife and you don’t understand why I thought this headline was funny, let me break it down for you. The first line of that story was, “Yields on long-term U.S. government debt moved abruptly higher last week, calling into question the durability of the more than nine-year-old bull market for stocks.”
First, rising interest rates do not kill bull markets; they actually go hand-in-hand with bull markets. I know this is counter to what you have learned from every financial media outlet and the short-term traders who often sit at their desks, but it is true. In fact, it is “textbook,” as they say.
If you wish to get full credit on the relationship with interest rates and stocks on your Level III Charter Financial Analyst (CFA) exam, you had better understand this fact. Let me make it simple: when confused, always go back to the basics. What is stock? On a daily basis it is easy to fall into the trap that stocks are just digital notations (formerly pieces of paper) that are randomly traded back and forth, but that isn’t true. Stock is ownership in a company. When a company’s business is good, the owners are rewarded. It’s that simple.
So, what are bonds? Bonds are loans. When a government or a corporation needs to borrow money, they issue bonds, which is just like you or me going to the bank to borrow money. The interest rates we pay are going to depend on our credit, and on the demand for loans. If the bank is overrun with customers wanting loans, then they can charge higher rates; if we are the only ones in there, then we can negotiate lower rates. Interest rates go up as the economy grows faster.
When the economy grows faster, people buy more products from more companies, which means companies make more money. When companies make more money, stock prices rise. Interest rates and stock prices go up together. The problem with markets is that they tend to get overheated and go too far; that is when stocks go down, and then interest rates go down. Then they do it all over again.
So, are things overheated? With interest rates this question almost answers itself. We have gone from historically low rates to low rates. We have not even really gotten back to normal, so the idea that we are overheating there really is not even being discussed.
Stocks, on the other hand, are coming up on a nine-year bull market run, right? Wrong. This headline is at best misleading and possibly just a lie. It is true that through the marvels of flawed design and questionable math the S&P 500 index has been positive for that many years, but stocks as a whole have not.
The market has corrected several times in the last nine years. We practically had a bear market (by definition, a market down 20 percent in price) in 2015 for every stock except the so-called FANG (Facebook, Amazon, NetFlix, Google) stocks. The FANG stocks then corrected in the beginning of 2016. We are in a bear market right now for Chinese companies, and international stocks as a whole have been hit hard this year. Small company stocks, which had finally come back to life after suffering for most of this nine-year period, have been hit hard of late. So, for anyone who has looked more closely than the most casual observer, this has not been an uninterrupted nine-year run.
This can’t be the end of the nine-year bull market because it has ended and then started again three or four times already. The economy is good; in fact, it is very good. That means rates will rise and companies should continue to report stellar earnings. Any market fluctuations in the meantime are just an opportunity for the long-term investor.
One final thought: Bubbles never burst when people are fretting about this possibly being a bubble. Bubbles burst when everyone is saying, “This time it is different.” In 1999 I was told by a colleague at Invesco that, “valuations don’t matter anymore.” In 2007 I was told by a hedge fund manager that one could “buy mortgage-backed securities and use as much leverage as you need to achieve any return you wish to earn and it is all risk-free.” When people start to talk that way, then we will be nearing the end of the run. Until then, when you see panicky headlines, do what I do and laugh and get ready to go shopping.
Chuck Osborne, CFA
~Up, UP and Away!
I don’t speak often about the size of Iron Capital because to me we are a small, close-knit team and I like it that way. The world, however, judges investment firms by assets under management, not headcount or office space, so Iron Capital is consistently listed as one of the larger firms in the Southeast. That achievement and five dollars gets me a coffee at Starbucks. But, while that is usually much ado about nothing, every once in a while it can be helpful.
For instance, I get the occasional invitation to visit the Federal Reserve Bank of Atlanta (Fed). The last time was about two weeks ago, when I went to hear a presentation from Steven Durlauf, economist and public policy professor at the University of Chicago. He was speaking on inequality. I was interested because I’m not sure if there is a more important subject for the long-term viability of the American experiment in self-government. I found his talk disappointing because he offered no real policy solutions. Oh well.
Even when the speaker disappoints, these evenings are worthwhile because one often gets to talk directly to some of the economists at the Fed. I love talking to the people who actually do the work. That is true when I visit our corporate clients, and it is true at the Fed. Talking to the rank and file is how you find out the truth.
In this case, we spoke about what the Fed was hearing from the front line. For those who are not familiar, the Fed is mostly known for controlling short-term interest rates. Lots of analysis goes into these decisions, and they have teams of economists whose primary job is to collect data. Mostly, they talk to business owners and corporate managers and ask them how things are going. The conversations of late were all surrounding trade.
The big question for our economy is: How much of the good done by tax reform and regulatory relief is being undone by tariffs? From what I heard, quite a bit. It is important to understand that the goal of the tax reform was to stimulate corporate investment. In other words, make it more attractive for companies to expand their businesses through new facilities or even just new, updated equipment. This corporate investment leads to growth in productivity, which leads to wage growth. These are precisely the elements that have been missing from our economy since the dot-com bust.
All the data show that tax reform was beginning to show signs of working. One example I learned of that night was a company headquartered out of New Orleans that was about to break ground on a brand-new factory. They were putting their tax savings to work, just like the policymakers had hoped. Then came the talk of tariffs; construction cost for the factory rose with the tariffs on steel and aluminum. The company in question was a chemical company which, although small, sells most of its goods overseas. They are now concerned about retaliatory tariffs on their products. The factory is back on hold.
That means lost jobs and lost wages to their employees. This is the real-world impact of trade wars. The huge multinationals have locations everywhere and can work their way around almost any web of trade barriers; it is the small, locally owned and operated companies who will not be able to compete. The companies that can’t afford the rise in steel prices and the ones that can’t just shift production from one plant to another. These are the companies that really spur growth, the ones who finally thought they saw a light in the end of the tunnel with the first market-friendly policy shift in almost twenty years. Then the rug was pulled right from under their feet.
The Trump administration assures us that these are just negotiating tactics and that we may have to live with short-term pain to achieve long-term gains. Perhaps they are right; we certainly hope they are. In the meantime, second-quarter GDP growth came in at 4.1 percent, which is actually very good, but almost a full percent lower than what many had been predicting. A percent may not sound like a lot, but in an economy the size of the U.S., that is a lot of growth to leave on the table.
What does this mean for our investments? It means uncertainty and volatility. Hopefully, as long-term investors we can take advantage of this, but the second half of this year is likely to be a bumpy ride. We still think it will be mostly up, but it certainly won’t be smooth. We remain vigilant, as always.
Chuck Osborne, CFA
~An Evening at the Fed
Different people see the world differently, and until you learn that, it can be difficult to communicate with someone who simply does not see what is so plain to see from your perspective. For me, it is connections. I see connections almost everywhere and sometimes I can grow impatient with people who don’t see it.
We currently have two connected things happening that I am not sure many people see. The administration is negotiating trade with the European Union. There is a threat of adding a 25 percent tariff on auto imports from Europe. Let’s ignore for a second that European car companies currently export more cars from their plants here in the United States than they import. There is a reason the new football and soccer stadium in Atlanta is named Mercedes-Benz Stadium, and most BMWs one might see on American roads were built in South Carolina. But we are going to pretend that German vehicles are actually all made in Germany. Even in this fictional world, does the tariff threat make sense?
The idea of tariffs on foreign cars is to protect our car companies from unfair competition. By adding 25 percent to the cost of foreign cars, our car makers can afford to sell their cars at a higher price and still be competitive. There is just one problem: We also put tariffs on aluminum and steel. This may seem like a totally unrelated issue, but they are connected.
Wednesday morning General Motors (GM) reported earnings. They actually did ok for the past quarter, but they reduced their full-year guidance. For those who don’t spend their lives analyzing the stocks of companies, managers of companies whose stock is publicly traded usually share with investors what they believe their short-term business results will look like. We call this guidance. In the case of GM, how many cars do they think they will sell and how much money will they make on each car.
GM told us today that they will make less money on each car because the cost of aluminum and steel has increased exponentially. Stock of General Motors is, as of this writing, down more than 7 percent. A 25 percent tariff on European automobiles will not overcome the increase in steel and aluminum cost. GM and Ford will still lose. I am guessing that Chrysler will end up having to pay the tariff since they were given to Fiat and are therefore European. Even if I’m wrong about that, they still lose.
Of course, the biggest loser in tariffs is the consumer, or to be more clear, you. Cars are about to become more expensive, and when this happens, many people will be out blaming it on capitalism. They will all but forget about the tariffs that started this painful cycle. They just don’t see the connections.
The administration says that all of this tariff business is part of negotiating. They say they would actually like to see no tariffs. This is just the “art of the deal.” In this regard we all should be pulling for them, because if this all works then it will lead to a better world. I have my doubts about this working, but there is no doubt that in the meantime GM’s stock is down 7 percent and the markets as a whole are just stuck and going nowhere. They are going nowhere in spite of a currently growing economy. They go nowhere because the threat of tariffs loom. You see, it is all connected.
Chuck Osborne, CFA
~It’s All Connected
Negotiating is almost always ugly. In my family we learned to negotiate as soon as my oldest sister could drive. My sister’s new license meant that Dad didn’t have to go with us to pick out our Christmas tree. He gave us about half the amount of money we actually needed and told us to go get a tree. Somehow, we always did. I remember my brother showing the tree salesperson all the needles falling off the tree. The man asked, “What do you expect this close to Christmas?” To which my brother responded, “I expect a bargain.” Those were the days.
This skill came in handy when my college girlfriend needed help buying a car. At the last second, the dealer added one of those not-previously disclosed fees. If I recall correctly it totaled about $1,000. I stood up, helped my friend up, said thank you anyway and started walking for the door. By the time we got to the door, the fee had disappeared. We turned around and completed the purchase. This is why car dealerships are now “no-haggle.” Now everyone just pays more, but we’re happy about it.
Well, this administration haggles and so do the Chinese. The markets, let’s face it, are dominated by young professionals (or the computers those youngsters program) who never had to bargain for anything. I learned this the hard way a few years ago when my wife and I sold our old house. A young couple made an offer, we countered, and they disappeared. They are probably still crying in a real estate agent’s office somewhere. They don’t like negotiating, and they sure don’t like doing it the way this administration does it.
This market is becoming more and more fixated on trade and it is getting ahead of itself. The market, after all, does not reflect the present; it reflects the consensus of what the future will look like. When the trade talk started it reflected winners and losers; now in the past few days it has seemingly shifted to predicting that everyone will lose. The market is telling us that the trade disputes with China will offset the economic benefits of tax and regulatory reform and plunge us back to the new normal. This means people are selling everything except the high-growth FANG stocks. It is 2016 all over again. For a week anyway.
The market is not always right, and at the very least it would seem that it is early. The real economy doesn’t change that quickly. It is also possible that Trump could win this. The market isn’t giving him much of a chance, and I readily admit that I have my doubts.
When my brother got us that Christmas tree bargain, the owner of that tree lot knew that once Christmas had come and gone those trees would be almost worthless. When I helped my friend get her car, that dealer had to make room on his lot. China, on the other hand, doesn’t have to do anything. Trump is guaranteed just two more years in office, and if he were to win re-election that would be six years. Since Trump, Peter Navarro, and Wilbur Ross are the only three people in the free world who don’t seem to understand that trade is good for America, it is doubtful – regardless of party affiliation – that the next President will be as aggressive with China. Long term to the Chinese is more than one generation. They have just given their leader a lifetime term. Six years is nothing. Time is on their side, and time matters when one is trying to perform the art of the deal.
I could be wrong. The Chinese may cave to administration demands, and supposedly if that happens, then free trade here we come. I doubt it, and so does the market.
The question for us now is, how much damage will really be done? Presidents of both parties have done economically stupid things since the beginning of our nation and we have survived. The economy is good now and has been getting better. I suspect the market is overreacting to how bad this will really be. Which, of course, is unknowable.
That is why we don’t really try to guess the impact on the entire economy. We invest from the bottom-up. It is much clearer how this does or does not impact individual companies. We will be focused on what actually happens to sales and earnings at the companies we own. That is prudent investing.
Negotiating is ugly. Sometimes it is better not to look.
Chuck Osborne, CFA