“In a moment of decision, the best thing you can do is the right thing, the next best thing is the wrong thing, and the worst thing you can do is nothing.”

That quote is often attributed to Theodore “Teddy” Roosevelt. Like many internet quotes, scholars can find no record of him ever saying it, but it sure does sound like the man who gave us “The Man in the Arena,” the most famous stanza in his “Citizenship in a Republic” speech delivered in Paris in 1910.

Teddy passed away a little more than 50 years before the first “passive” index fund was created, but I feel confident that he would not have been a fan. The world is full of people who will tell investors they should invest is index funds because you can’t “beat the market.” There are, however, far fewer who can explain why that is supposedly the case.

The theory that spawned the index fund to begin with was explained in Eugene F. Fama’s 1970 paper, “Efficient Capital Markets: A Review of Theory and Empirical Work.” Fama argued that the market was “informationally efficient;” in other words, all available information is reflected in the current price of any asset (in our case stocks). In theory, the market price of a stock is always the “right” price; thus, no value can be added by choosing to invest in one stock over another. This efficient market theory then brought us the capital asset pricing model (CAPM). Every former finance student just had a shiver go down their spines at even the mention of it. CAPM is predicated on the assumption that markets are efficient and if trading were free, then the most efficient portfolio would be one that simply weighted stocks based on their capitalization. In plain English, an investor should invest only in the largest companies based on nothing but the fact that they are already big. Index investing was born. This is what the vast majority of index funds do.

The point of explaining the theory behind index investing is hopefully to drive home one simple idea that very few index investors have ever thought about:  Indexing only works in an efficient market, but the market is made efficient by investors making independent active decisions based on the latest information available. Put simply, index investors are freeloading on the market created by active investors. It has worked for many years, but something has recently changed.

In their paper, “The Active Side of Indexing,” authors Rob Arnott and Lillian Wu outline the growth of index investing over the last 40 years. As recently as 2000, index funds held $0.4 trillion, or barely 3 percent of U.S. equities; as of December 2024, they now hold $13 trillion directly tracking the S&P 500 alone, which represents 21 percent of the value of the entire stock market and more than a quarter of the value of S&P 500 member stocks. In 2024, for the first time in history index fund assets surpassed those of active U.S. equity funds.

These numbers only scratch the surface. One thing the index investors get right is that the average money manager does not beat the market – after all, in a world without grade inflation, average is a C. Most of these average managers end up being closet indexers because they are afraid of ever trailing the index long enough to get fired. It is impossible to know exactly how many assets are managed this way, but it is a sizable number.

One thing index investors get wrong, which I pointed out in our latest The Quarterly Report newsletter and Arnott and Wu point out in their paper, is that they believe index investing is passive, when in fact it is not. The current turnover in the S&P 500 is approximately 15 percent, but Arnott and Wu use a much more conservative 5 percent. More important than the exact percentage is the index is weighted by capitalization, in other words the total value of the company. The companies being removed tend to be companies whose stock price has dropped, while the companies being added tend to be companies whose stock price has suddenly risen.

In addition, within the index, company weightings will change as some stocks rise and some fall. Every time an index fund gets new money invested, it has to then buy more of the stocks that have already risen and less of the stocks that have already fallen. Index investors are constantly buying high and selling low. This is active, but more precisely it is one particular active strategy: momentum investing.

The idea behind momentum investing is simple. Stocks have momentum, so when they are rising they will tend to keep rising, and when they are falling they will tend to keep falling. Of course, they do this until they don’t. At some point the stock price gets so high that no one will buy, and at some point, the price gets so ridiculously low that investors begin to buy. Momentum investing is therefore a short-term trading strategy, and it is very popular with traders.

Historically, momentum would be kept in check by active investors who would take advantage of the short-term momentum to take profits or buy good companies on the cheap. This is what makes a market – some investors buy while other sell, and vice versa.

As more and more of the long-term investors have moved to the index, we no longer have people on both sides of any trade. Snowflake, a technology company whose stock we own in our most aggressive strategy, recently reported earnings and the stock jumped 38 percent on that day. Through June 1 the stock was up 66 percent over the last three months, which makes it up 27 percent year to date; So, prior to jumping 66 percent, the stock had been down almost 40 percent…one cannot be a snowflake if she wants to invest in Snowflake (I apologize for the pun but couldn’t help myself).

The company itself is doing very well, but it did not grow business 38 percent in one day and business had not been down at all, let alone 40 percent, previously. The fact is that there was just no one on the other side of these trades. Anecdotally, we have heard this over and over again from mangers who historically would have “bought the dip” in a company like Snowflake, but now they are scared to do it. They are afraid to jump in because momentum is overwhelming fundamentals.

It is not just Snowflake. Intel – boring old, been-around-forever-Intel – jumped 23 percent on its most recent earnings. How does Intel jump 23 percent? There was no one willing to sell. When everyone is on the same side of every trade, then we no longer have a market. Real-world investors have been poking holes in efficient market theory and CAPM for as long as I have been in the business. Nothing was in either of those earnings reports that would change the value of those companies dramatically.

Thus far the ordinary investor has not noticed this enormous increase in volatility as it gets balanced out at the index level. The question is, how much longer will it be hidden? Will we see double-digit moves in one day for the index?

The market has always been irrational in the short run, and it has done a great job in the long run. Will that still be the case when no one participates, and everyone just tries to freeload? I don’t know the answer, but I strongly suspect Teddy Roosevelt would tell us to look to our inner American spirit and make a decision. At Iron Capital, we are going to continue to invest intentionally; we might just need a little more patience.

Warm regards,

Chuck Osborne, CFA

~Is the Market Broken?

I love spring. In my home state of Georgia, there is a significant event which marks the season every year: The Masters Tournament, the annual golf tournament that transcends the game. One does not have to be a golfer or a golf fan to be a fan of the Masters; like the Super Bowl, Wimbledon, and the Kentucky Derby, it is bigger than its sport.

I don’t have the time to play as much golf as I used to, but I still enjoy watching the Masters. This year I missed most of it due to other obligations, so I caught up in the evenings by watching highlights and listening to the golf punditry. Rory McIlroy won his second Masters in a row. He leapt out to a 6-stroke lead after the first two rounds. While there have been six other players in Masters history with 5-stroke leads at the same halfway point, the 6-stroke lead was the largest. Of those other six players, all but one had gone on to win, and Rory was one shot better than all of those. The pundits all agreed the tournament was over and spent most of their time asking each other if anyone other than Rory would ever win The Masters again.

Then Saturday happened and Rory came back to earth. His 6-shot lead disappeared, and he would enter Sunday’s round tied for the lead. Every pundit who was all in on Rory just the night before now picked someone other than Rory to win. I was trying to watch purely as a golf fan, but I can’t help being an equity analyst at heart. I sat there thinking, “Nothing has changed, Rory is going to win.” Only one time in Masters history had anyone had a lead close to Rory’s and lost. Rory is one of the greatest golfers of this generation; he wasn’t going to lose.

Rory went on to win. Ultimately he won by one stroke, but he had a comfortable lead coming down the stretch that allowed him to bogey the last hole and still win his second Masters. All the pundits praised his resilience, ignoring the fact they had turned on him just 24 hours earlier.

What does this have to do with the market? Everything. This is human nature. When a stock is going up every pundit out there will tell investors how wonderful the company is and how it will grow forever. When the same stock has a setback, the same pundits will then tell you it is time to jump ship and bet on some other company. Then the original stock will bounce back, and the pundits will return to singing its praises as if they never doubted it for a second.

There is a reason that major golf tournaments are played over four 18-hole rounds for a total of 72 holes, and that prudent investing is done over the long term. Over that long haul, everyone will experience ups and downs. There will be hot streaks and cold streaks. That is how life works: everything comes in waves. What matters is having the discipline and resilience to keep going, knowing that in the end, if one has done all the right things, then the result will be a good one.

Things are never as good or as bad as they seem – whether it’s 6-stroke leads, attacks on Iran, AI, whatever it may be. Unfortunately, most investors are like those pundits who couldn’t abandon Rory fast enough – they get excited when things are up and abandon ship when the downturn comes. The winners are the disciplined ones who choose their investments carefully from the bottom-up and then have patience. Winter always comes, but it is also always followed by spring. I love spring.

Warm regards,

Chuck Osborne, CFA

~Mastering The Market

Does anyone else know what it is like to have teenagers in your house? The only way parents survive the drama is with the knowledge that these volatile creatures were once their adorable little boys and girls, and will one day be endearing humans once again.

When I take a deep breath and remind myself that our little girl is still in there somewhere, I remember back to when my daughter’s favorite show was a Disney cartoon entitled, “The Lion Guard.” There was one episode in particular when the Lion Guard was trying to help a zebra whose herd was under attack by hyenas. The zebra’s reaction was to panic and run. I can still see my daughter dancing around the house singing, “Panic and run, panic and run!” It made for a cute children’s show, but obviously panic is not really a good investment (or life) strategy. One wouldn’t know that if he was paying close attention to the markets today.

If there is one strategy in investing that is universally preached, it would be diversification. We all know that we shouldn’t put all of our eggs under the same layin’ hen (at least you do if you read the First Quarter 2024 issue of The Quarterly Report). We have to diversify our investments. The theory of diversification rests on owning assets that have low (maybe even negative) correlations with one another. For example, stocks and bonds: The idea is that when stocks sell off, investors should go towards the perceived safety of bonds and therefore bonds will increase in value as stocks decrease in value, helping to reduce the volatility of one’s portfolio.

Asset allocators, whose job it is to figure out how exactly investments should be mixed together to optimize risk and return, obsess over correlations. It does work, most of the time. However, there is one problem: In times of true market distress, all correlations go to one. In plain English: When something really scares the market, such as a financial crisis or a war in the Middle East, all well-conceived investment strategies turn into “panic and run.”

Since the first attacks on Iran on February 28, the S&P 500 is down approximately 4 percent.  On February 27 (the day before the attack), the 10-year U.S. Treasury had a yield of 3.97 percent. In other words, the interest rate on a 10-year loan to the U.S. government was 3.97 percent. On March 24, that interest rate is now 4.4 percent. As a reminder, bond yields and bond prices have a see-saw relationship. When yields go up, it means prices have gone down. So, investors are selling stocks and they are selling bonds.

Maybe they are only selling U.S. bonds since we started this war? Nope, the German Bund (German for bond) had a yield of 2 percent on February 27 and now yields 3.03 percent.

I know what you are thinking: Gold is the safe haven, that is where smart people put their money today. Nope, gold was $5,230 per ounce the day before the attack and it is now $4,375 per ounce. Should I keep going?

In times of crisis, correlations go to one and diversification is not of great help. So, what are investors to do? It is at times like this that investors need to know what they own and know why they own it. Great investors are owners of companies, not traders of stocks. While Wall Street is in full panic and run mode, selling almost everything, out here in the real world, life goes on. Apple is still selling phones. Alphabet is still helping people Google the latest information. Have you seen the lines at the airport? Delta is still flying people (or leaving them if they didn’t get through security in time).

Sometimes the best way to handle a storm is to batten down the hatches and just sail through it. This too shall pass. That is the mantra for the day in the market and in all those households with teenagers. The war will end and we will get on with our lives, at least that is what my wife and I keep telling ourselves.

Warm regards,

Chuck Osborne, CFA

~Panic and Run!

“Han Solo:  How we doin’?
Luke: Same as always.
Han Solo: That bad huh?”
~ “Star Wars, Return of the Jedi”

I was reminded of this fictional conversation as I drove to work this morning. We were already in one of those no-win moods on Wall Street, and now we can add unrest in the Middle East to the long list of worries.

Casual market observers may wonder what I mean as the headline S&P 500 has not been that bad, but as I always say, it is what happens underneath the surface that tells the real story. We are in a full-blown bear market for software company stocks, thanks to the narrative that people and enterprises will just use AI to create custom software. These stocks have been badly beaten up as a result.

The full narrative goes a little something like this: AI is taking over the world, humans will no longer have jobs, and no one will use pre-packaged software to do work on a computer. This narrative exists in concert with another that has AI company stocks down because “companies are spending too much on AI and they will not be able to get a return on these investments because AI is overhyped.”

These narratives contradict one another, but when was it ever necessary for the market to make sense?

The average index investor has missed all of this fun because we have seen a large rally in industrial company stocks and the stocks of consumer staples. Coca-Cola is up more than 35 percent over the last month, and Deere & Company is up approximately 40 percent year to date. Nothing runs like a Deere, but that is a remarkable short-term gain for a company that is still experiencing a downturn in its actual business. I have lived in Atlanta my entire adult life, and few things are as refreshing as an ice-cold Coke on a hot day, but this is 2026 and sugary soft drinks don’t scream future.

Now we have to add war in the Middle East to the situation. So, how we doin’? Same as always. But is it really that bad?

In the real world, away from Wall Street’s narratives, technology companies are doing really well. This includes both software companies and AI companies. Can AI write code and therefore replace the need for software? Maybe, but that’s like saying a coffee maker will replace the need for Starbucks. Sound ridiculous? Just because something can be done, does not mean it will. People choose to go to Starbucks rather than making coffee at home, and people and enterprises will likely choose to buy software rather than developing it themselves because they would rather have their AI agents working on making their actual business more productive than building software that they could just purchase. Let’s put it this way: If the business didn’t see the value in hiring human coders, then why are they going to want to train AI agents for that purpose?

Does this mean AI is overhyped? No; business leaders will likely use AI to get the most out of the software they already have, which would greatly enhance productivity. One thing I know for certain: technology leaders are not the right people to ask about the future of AI. They are brilliant, but they are too close to the situation to see the big picture and they don’t understand how non-tech (often non-brilliant) people think.

What about Iran? What is happening in the Middle East today is more important than anything in the stock market. However, it is our role to discuss impacts on investments. In the short term this may finally be the trigger for a correction. No one likes market corrections, but they are a healthy part of long-term bull markets. We are overdue, and this would likely help correct some of the absurdities we have discussed. In the longer term it is not likely to have a large impact on the market.

Irrational short-term trading and war in the Middle East? I think Luke was right: this is the same as always.

Warm regards,

Chuck Osborne, CFA

~If The Iranians Don’t Get Us, The Machines Will…?

“He’s making a list, and checking it twice, gonna find out who’s naughty or nice. Santa Claus is coming to town!”

So, have we been naughty or nice? Will we finish the year with a little Santa rally, or will we end up with a lump of coal? Its hard to say.

In preparing for this annual Christmas Insight I reviewed what I wrote the last few years. While I have promised not to use AI in our writing, it is tempting to cut and paste those previous December Insights. Like 2023, this has been a strange year, especially in the second half. Take small-company stocks in the Russell 2000 index: At the end of the third quarter, stocks of companies in that index that are losing money were outperforming the stocks of companies in that index that make money by more than 30 percent.

This phenomenon led to the narrative that we are in an AI bubble, which in turn has led to a strange quarter where seemingly company after company reported better-than-expected financial results only to watch their stock prices drop as a result. One such example is Duolingo, which grew revenue at 41 percent and earnings at more than 1,000 percent to then see its stock drop 25.5 percent the day they announced these results. Doesn’t seem to make sense? It doesn’t have to make sense. Markets allocate capital over the long term better than any other method, but in any given short-term period, all kinds of crazy things can occur. This is why prudent investing requires patience, which was our theme in 2023.

In both 2023 and 2024 there was lots of talk about the market being expensive. It still is expensive if one simply looks at the top-down index view. There are some differences, however. The S&P 500 has been very top-heavy; the valuation is skewed by the very high price of the largest few companies. In 2023, we were describing these as the Magnificent Seven. In 2024, we talked about large-growth companies in general being very expensive relative to earnings. Based on our proprietary work, they were two standard deviations above average, which in plain English means they reach prices this high only 5 percent of the time.

In both years we pointed out that there are several areas in the market that were not at these really high prices, and that observation has played out over the last few years. As we finish 2025, value stocks have rallied. The stocks portion of our income strategy, which is meant for investors who are either very conservative and/or in retirement and needing income, is up more than 23 percent, net of fees, year to date through December 17. These are the most conservative value stocks that we own and they have outperformed not only the S&P 500 but also our most aggressive strategies. Last year it was the opposite. I have said it before, and it bears repeating: We did not wake up on January 1, 2025, and forget how to invest for growth, nor did we not know anything about income strategies in 2024. This is how markets work; there is a give and take.

One of the companies we own in our income strategy is Rio Tinto, a mining company that mines several different minerals but primarily iron ore. Rio’s stock price is up 19.78 percent over the last three months and 37 percent year to date through December 17. Its stock price alone (not including the sizable dividend) is up 32 percent total over the last three years. In other words, the stock price was down approximately 5 percent going into the year and not even that great until the last three months. This is how stocks actually move and what makes investing so difficult; they stay relatively flat for long periods and then jump. This behavior is what fools investors into believing they can time things that cannot be timed.

In 2023, it was the Magnificent Seven. In 2024 it was technology, more broadly and AI. Now we are seeing value finally get into the act. So, what will Santa bring us this year and how will this play out in 2026? Honestly, I am not sure, but I do know one thing: the market is running out of places where lower prices can be found. Based on this run, large value stocks have joined their large growth cousins in being unusually expensive.

I suspect that the New Year will bring a rally in technology and AI-related stocks, which have been selling off as of late, and perhaps a drop in the value stocks that have rallied. After that, it will depend on the economy. High prices alone do not cause markets to drop, but high prices combined with disappointing results will. Can the economy hold up and allow corporate earnings to grow into these valuations? That is the question of 2026.

In the meantime, we wish you all a very Merry Christmas and a Happy New Year!

Warm regards,

Chuck Osborne, CFA

~Which List Are We On?