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.
It has been one of those years thus far. We are in a dark cloud. Inflation has come back; we have an actual war going on; the stock market has gone bear market territory; and the bond market has produced historic losses. So where is that silver lining?
The market has a case of the glass-half-empties. Earnings have been mostly good, but the market would rather focus on the few negatives. Underlying all of this is slowing economic growth and high inflation, combining to take the market roughly back to the lows we had seen earlier this year. We are now at a turning point.
These days, every time a Fed member speaks, the financial press and short-term traders parse every single word. The market is trying to rally and come back from the correction of earlier this year, but every time we start to make serious progress, some Fed official insists on stepping in front of a microphone.
Eventually the fog lifts and the world reappears. When it does, there are opportunities for investors. Prudent investing is really simple but extremely difficult, because the best time to buy is when everyone else wants to sell, and the best time to sell is when everyone else wants to buy. That takes discipline.
Our focus determines our reality: what a great life lesson, and it holds true in the markets as well. Currently we are focused on Russia’s invasion of Ukraine, and that has put the market in a foul mood. This situation with Russia is serious and I do not want to suggest otherwise. Having said that, our focus here is financial.
“It’s a dog-eat-dog world, and I’m wearing milk bone underwear.” – Norm, “Cheers”
It has been one of those years thus far. We are in a dark cloud. Inflation has come back, even though we learned this lesson in the 1970’s. We have an actual war going on, as in one nation invading another. The stock market has gone past correction and into bear market territory. More importantly, the bond market has produced historic losses.
Through Wednesday, May 11, the S&P 500 is down 17.03 percent year to date, with many areas of the stock market doing much worse. Normally in times like these the bond market would be rallying as investors fled stocks and moved into bonds to reduce risk, but not today. I know I sound like a broken record, but stocks actually do act as the best hedge against inflation in the long run. The problem thus far this year is that inflation is accompanied by fear of recession.
Bonds are usually a hedge against recession fears, but the problem this year is that recession fears are accompanied by inflation. Inflation destroys bonds; the reason for this is self-evident if we take the time to remind ourselves that bonds are simply loans. If we borrow money at 3 percent interest, our loan payments would be attractive income for an investor when inflation was nonexistent. With inflation at 8.3 percent, that 3 percent interest payment now represents a 5.3 percent loss of purchasing power. Bondholders are actually losing money when inflation is considered. So, they are selling, and as a result the U.S. aggregate bond index is down 9.5 percent year to date through May 11.
For the stock market to recover from a 17 percent drop, we would need a 20 percent rally. This happens in the stock market frequently and would be easily done. For the bond market to recover, we would need a rally of 10.5 percent. It could happen, but it is not likely. The yield on the 10-year Treasury bill is trading in the neighborhood of 3 percent. That means the most likely return on those bonds is 3 percent. In other words, stock investors are experiencing short-term pain, but will recover and move forward in all likelihood. Bond investors have no such prospects.
To add insult to injury, many bond investors are retirees who are counting on that income to fund their retirement. They have already had to settle for historically low yields, which has reduced the income possible from the traditional bond approach. Now the people who failed to adapt to the low-interest world we were living in are getting punished more than anyone else.
So where is that silver lining I mentioned in the title? Iron Capital did adapt, many years ago. Our approach to producing retirement income is unique, and it has held up well. Year to date, the average of our income portfolios is still down 6.34 percent, but that is much less than traditional income portfolios, and our approach also provides an opportunity for recovery. We build portfolios that produce the income needed, or as close as possible, while taking the least amount of risk possible; over the last several years that means we have been focusing on dividend-paying stocks. These have been in places like energy, utilities, consumer staples. The areas that have done the best in our current environment.
This was not some sort of miracle foresight; no, we just followed our process, and that process led us to portfolios that many would describe as more risky than traditional bond-heavy portfolios. That is because many are stuck defining risk as either legal structure or volatility. Risk is losing money, and our approach to investing during the most risk-sensitive time in one’s life has held up much better. That is a silver lining in this dark time.
I know, some are reading this and saying, “How does that help me, I’m still trying to accumulate for retirement.” I feel that pain, and times like this are always painful, but they will pass, and the stocks will rise again. It always happens faster than one thinks possible. Meanwhile we will do what we can to protect our client portfolios. One day you will be retiring yourself, and it is good to know that it can be done, even in an environment like today’s.
Chuck Osborne, CFA
This has been frustrating. The market has a case of the glass-half-empties. Earnings for the most part have been good, but the market would rather focus on the few negatives. We had a big up day when Meta (formerly known as Facebook) reported much-improved numbers, then Amazon disappointed. The cloud business, which is the primary focus of Wall Street, grew only 37 percent instead of the 40 percent that it had been growing. Amazon’s stock was punished along with the rest of the market because of the slowing growth. Seems a little overly harsh to me.
On the other hand, Apple reported a solid quarter and the stock initially rose, but then Tim Cook explained that there are still supply issues coming from China, and the stock went down. Never mind that he said the same thing last quarter, before the company delivered these good results. We are just in a foul mood, and any little excuse leads the market down or thwarts any attempt at a rally.
Underlying all of this is the environment of slowing economic growth and high inflation. The initial reading for Gross Domestic Product (GDP) came out for the 1st quarter of 2022 and the economy shrunk by 1.4 percent. Meanwhile, we have 8.5 percent inflation. The Fed is making hawkish statements and the market is nervous, but then raised rates by 0.50 percent as expected. The Fed bark remains much fiercer than its bite and one wonders when the market will ever learn that lesson. Many pundits were suggesting that the Fed may raise by 0.75 percent or even higher. Chairman Powell said after their meeting that this was not even discussed. In other words, it was never even on the table.
The economic concerns are real but seem overdone. Unemployment is the key to an actual recession. Unemployment is currently at 3.6 percent and the consumer is relatively healthy. While GDP came in at a negative number, consumption from consumers actually rose approximately 4 percent. The previous read from GDP was 6.9 percent growth, which was driven by inventory-building. This was a makeup from the previous quarter, when we saw significant supply chain issues. It appears to have been an overshoot, which means there was slower inventory-building this quarter, leading to negative growth. Other contributors were slowing of government spending, as we have gotten past the various stimulus measures, and growing imports, which are actually counted as a negative. These are not the makings of a recession.
All of this has combined to take the market roughly back to the lows we had seen earlier this year. We are now at a turning point. Does the market bounce from here, or does this prolonged correction turn into something worse? We believe the market should bounce. Company earnings have been strong, and that is what should matter. While major indexes still appear expensive, this is driven by a small number of large companies. Take those away and stocks are attractively valued. Now the Fed has moved as most expected, and not more dramatically as some feared. The rational move is for stocks to go higher.
Of course, in the words of John Maynard Keynes, “The market can remain irrational longer than you can remain solvent.” While we believe the market should go up from here, we cannot ignore what the market is actually doing. We are watching this point closely and will take action to protect portfolios as needed.
Chuck Osborne, CFA
“Even a fool, when he keeps silent, is considered wise. When he closes his lips, he is considered prudent.”
– Proverbs 17:28
I have some free advice for Jerome Powell and the rest of the Federal Reserve board members: Shut up! Perhaps I am guilty of romanticizing my early career, but I really miss the days when the Fed just went about its business in silence. Do we really need to know every thought that crosses the minds of the various Fed members?
The market fixates on every breath as if it means something. The minutes come out and some members wanted to be more aggressive. They got out-voted – so what? The Fed did what it did, and that is really all we need to know. Besides, one cannot tell from minutes alone the seriousness of a conversation. Have market participants ever been in a meeting? In the adult world alternative points of view are often expressed so that we can think through them.
These days, every time a Fed member speaks, the financial press and short-term traders parse every single word. The market knows that inflation is the biggest economic concern; the market knows that this means interest rates will rise until inflation is under control. The market fears that the Fed (who, let’s face it, has messed up to allow inflation to take hold) will now mess up by over-correcting and putting us into a recession.
What does this mean for you? It means the market is trying to rally and come back from the correction of earlier this year, but every time we start to make serious progress, some Fed official insists on stepping in front of a microphone. The market mostly thinks that Fed members are foolish, but when they step up to the microphone and open their mouths, they remove any doubt that remained.
The greatest example of this was the taper tantrum of 2018. Fed Chair Powell gave a speech in October of 2018 suggesting that the Fed would start to taper its asset purchases. The market crashed. In a later speech he backed off on his earlier forecast, and in early 2019 the market took off like a rocket. Intelligent people will, to this day, say that the Fed “quickly changed policy” or “reversed course.”
The Fed did no such thing. Policy never changed during that time period. The only thing that changed was the tenor of Powell’s speeches. When eventually the Fed actually began to taper, it was a non-event from an equity market standpoint. What the Fed needs to do is stop thinking out loud.
But don’t we want transparency? Last night I enjoyed a sausage pizza with my kids. It was delicious. You know why it was delicious? Because we did not see the sausage being made. We need enough transparency to know that nothing unethical is going on, and no more. In other words, justify your actions after the fact, and stop telling us what you might do in the future. Stop thinking out loud.
This is not likely to happen, but perhaps the market could learn a lesson here: What all of this talk does, other than undermine Fed credibility, is create market expectations. Those expectations get reflected in Fed funds futures (contracts that predict future rates). Those futures are incredibly bad at predicting reality. According to research done by the CME group, they historically have been wrong by 75 – 175 basis points. Considering the current Fed funds rate is 33 basis points, these are huge misses.
Right now, the fear of the market is that the Fed is going to create a recession. That fear is overblown. Unemployment is currently at 3.6 percent. We are not going into a recession when 96.4 percent of workers are employed. Employment is the key statistic; as long as it holds up, we will avoid a recession, and there are currently no signs of the job market weakening. Of course anything is possible, but the probability of a recession when we have less than 4 percent unemployed is extremely low.
Currently we are at worst stuck in a market range, bouncing back and forth but going nowhere, and at best beginning to climb the wall of worry. The most recent market lows have been higher than previous lows, which is a good sign we may be moving ever so slowly up. The market is taking care of raising rates on its own, as the 10-year Treasury is approaching 3 percent. The Fed is still behind, if anything.
They could regain some credibility, perhaps even seem wise, if the Fed members would just keep quiet and do their collective job.
Chuck Osborne, CFA
~The Wisdom of Silence
The war in Ukraine has put a fog on the market. The rising cost of oil will exacerbate the already-high inflation. There is significant risk of a recession in Europe. Russia is un-investable and, in our view, will remain so, at least as long as Putin is in power. China was already having issues with its economy, as its regime continues to reverse the liberating reforms that had made China the economic power it is today.
There is lots to worry about as an investor, which is why we have seen a market correction. Corrections are not fun; in fact they are scary, as it always seems this could turn into more than just a correction. There are always arguments for why this time it is really the end of days and the market will go to zero…which causes stress, and stress literally causes tunnel vision, and all we can focus on are the negative news items, of which there are plenty. It is like being in a fog: one cannot see anything around them, only what is right in front of them, which today is the conflict in Ukraine.
Eventually the fog lifts and the world reappears. When it does – and it may already be happening – there are opportunities for investors. It may not seem like it, but then it never does. Prudent investing is really simple but extremely difficult, because the best time to buy is when everyone else wants to sell, and the best time to sell is when everyone else wants to buy. That takes discipline.
We find that discipline by focusing our investments from the bottom-up. We analyze individual investments on their own merit, instead of guessing where the market is headed or what the outcome of this crisis will be, or when the next crisis will come. That does not mean one can ignore totally what is happening around them, but the environment needs to be considered from the point of view of each single investment.
I was an economics student when the Soviet Union was collapsing. I found it fascinating, and I took every course I could that touched on it… unintentionally I ended up with a minor in international studies. One of my professors had Russian stock certificates framed and hanging on the walls of his office. They had been issued during the period known as the New Economic Policy (NEP). Lenin had tried to go straight for socialism, but that made people’s lives worse (as it always does, but that is a subject for a different day). So, he relented to some market-oriented reforms, and some companies were able to raise capital through the issue of stock.
Stalin could care less if people’s lives were miserable, so he reversed NEP, and in one day, those stock certificates became worthless as those companies were now property of the Soviet Union. Putin resembles Stalin more so than Lenin; therefore, even after this crisis goes away and markets reopen for Russian companies, one has to know that any company in Russia could simply be taken over by Putin, making your investment worthless. In our view that makes Russian stocks un-investable.
However, most companies aren’t located in Russia or Ukraine, and will continue to do business regardless of the outcome of this conflict. When we look at these companies, we put an estimated value on their business, then we compare that value to the actual price of their stock. The difference between those two is our expected return, should we invest. Those expected returns are the highest they have been in several years. To be honest, I’m not sure how long it has been since we have seen the expected returns this high.
What does that mean? It means companies are doing much better than their stocks. We have been saying it for a while, but inflation boosts companies’ reported earnings, and valuations are based on earnings, or more sophisticatedly cash flow. Higher inflation leads us to higher cash flows, higher earnings and higher company valuations. Eventually the fog will lift, and this is what investors will see.
We already see signs of it any time there is good news on the war front. We could see further setbacks. It could take months before we are completely out of this fog, or it could happen between the time I write this and when it published. That is the hard thing about investing. It is impossible to time the market. However, the fog will rise, and when it does, the future will look bright.
Meanwhile, our job is to manage your investments, so that is our focus. Simultaneously, our thoughts and prayers are with those in Ukraine. We also pray for our leaders, may they rise to the occasion.
Chuck Osborne, CFA
~When the Fog Lifts
Our focus determines our reality. There is a lot of truth to this statement. Psychologists tell us that too much focus on self leads to anxiety and depression, while focus on others leads to joy. Late last year we hosted a small party for my son’s 14th birthday. One of his friends unfortunately broke his arm during the party and we had to drive him to the emergency room at Atlanta’s children’s hospital. While he sat there in the ER waiting to be seen by the doctor, another boy came in with two broken arms. Our son’s friend said, “He must really be hurting, I guess I am pretty lucky.” It would have been easy to focus on his own broken arm, but he was focused on others.
What a great life lesson, and it holds true in the markets as well. Currently we are focused on Russia’s invasion of Ukraine and all of the geo-political tension that goes with it. That has put the market in a foul mood. We are in correction territory for the S&P 500. The index was up 11 percent in the 4th quarter of 2021 so some perspective must be given even on that statement, but still, a more-than-10 percent drop from highs is not fun.
This situation with Russia is serious and I do not want to suggest otherwise. I personally believe that Putin is a very dangerous man who needs to be stopped. Having said that, our focus here is financial, and this is not a real threat to the market. Sure, it can cause a temporary selloff as it has already done – but eventually the market’s focus will move on and we will see a rebound. There have been false starts as companies report good earnings and markets open positively. Thus far, the markets have lacked the strength to maintain that momentum throughout the day.
We may be in this pattern for a while. We did not foresee Putin flexing his muscles over Ukraine as an issue when we entered 2022, but we did see a tension between poor economic data and positive company earnings reports. When the market is focused on the big economic picture we are likely to see stocks go down, as the rate of growth has slowed and in all likelihood will continue to slow. Russia has just added one more negative thing on which the market can focus.
In the interim, expected returns for the stocks we follow are the highest they have been in several years. Earnings are being inflated, like everything else in our inflationary environment, and the stock prices have been cut. Lower prices and better actual results make for higher expected future returns. Of course, there is no guarantee – there never is – but this usually bodes well for future market returns.
At this moment we still see this downturn as an opportunity for long-term investors to pick up some bargains. What would change that? If we started to see companies report deterioration in their actual business results. This is what we mean when we say that we invest in companies and do not trade stocks. Stocks are pieces of paper – in truth they are not even that anymore, they are digital notations, but “pieces of paper” still sounds better. Pieces of paper react to all sorts of unrelated news. Being unrelated does not mean that the news is unimportant; what is happening in Eastern Europe is certainly important. It simply means that it is unrelated.
Russia and Ukraine have little to no impact on how many iPhones are sold, or how many Cokes are consumed. The tension between them impacts stocks much more than it impacts actual companies. This is how investment opportunities are made, when the price of the stock for some reason does not reflect the actual value of the company.
This doesn’t mean it will all be smooth sailing from here. The market can focus on the wrong things for a long time, but eventually the focus will come back to the actual companies those stocks represent.
We stated earlier this year that we expect returns to be more modest this year. We would be surprised if we see another high teen or even twenty percent year, but would be even more surprised if we end the year down. We still believe that, and that means up from here. Focusing on the state of global politics is often depressing. Focusing on what is actually happening with companies in which we are invested is far more joyful, and fortunately for us, that is what drives long-term results.
Chuck Osborne, CFA
~Your Focus Determines Your Reality