What a long, strange trip it’s been. We began 2010 by telling our clients that the market, as defined by the S&P 500, would end the year up 12%. We ended up being a little conservative, but half way through the year when we were sticking to our prediction, we probably sounded a little crazy.
The first quarter of 2010 was great and everyone was talking economic recovery. Then we rediscovered Greece, the historic birthplace of Western Civilization, now the birthplace of Western Welfare State Implosion. The second quarter was one of the most painful in recent memory, and after 2008, that is saying something. The difference this time is that the root cause of panic – the national debt levels of Western countries – doesn’t directly impact corporate bottom lines in the same way the credit squeeze of 2008 did, and ultimately equity valuations are about the health of the underlying companies, not what is happening to mostly European governments.
The summer was marked by the first real Wall Street vacation since 2006. Volume went away. The professionals weren’t working, the average individual investor was still in wait-and-see mode, and the only ones trading were those who have bought into the sky-is-falling camp. By August everything looked negative, the macro-economic news was worrisome, and I had people telling me I was crazy to be optimistic about the stock market and maintaining our 12% target on the S&P. Fortunately, the market stormed back starting in September and now I sound clairvoyant instead of crazy. (Truth be known I’m neither, but let’s not ruin a good story with too many facts.)
Those, however, are just the numbers. There were bigger stories under these numbers that may impact the market for a much longer time – starting with Goldman Sachs, accused of fraud in the creation of a derivative security for one of its hedge fund clients. This front page headline-grabbing investigation launched the day Congress began debate of the new financial regulatory legislation and was quietly dropped the day that legislation was signed into law. From a legal standpoint, Goldman was at worst a little sloppy in their disclosures of potential conflicts. However, from an ethical standpoint, this scandal highlighted the problems of Wall Street that we have been preaching about since Iron Capital’s founding in 2003.
Another underlying story was the so-called “flash crash” when the market seemingly dropped off a cliff and then bounced back up. It brought back memories of 1987, although thankfully this was not the beginning of a prolonged sell-off. The huge trading error increased the perception that investing in stocks is a rigged game.
Finally there are the allegations of insider trading, which started with a single hedge fund and now it look like an epidemic. Much of this latest bout of supposed wrong-doing involves the use of so-called expert networks. There are legitimate questions about whether the use of these networks is really insider trading or just analysts doing their proper homework. Hopefully we will see how many people really crossed the line when there are actual indictments and convictions. In the interim, the perception will be ‘guilty until proven innocent’ and yet another black eye on the face of Wall Street.
In the midst of all of this controversy, how can anyone trust the markets and have the confidence to invest in equities going forward? The first step is to open one’s eyes and not be naive. My father once taught me the difference between having a positive outlook on life and being in denial: someone with a positive attitude will look out the window during a thunderstorm and say, that’s okay we can have fun inside today. Someone in denial will look out the same window and tell you it isn’t raining.
We are not in denial. Wall Street firms are in the business to generate fees for Wall Street firms, not to give investment advice. The rate of return on their clients’ portfolios is not their concern, but fortunately there are firms like Iron Capital who obsess over their clients’ rate of return.
In a world increasingly driven by technology, errors and fraud are going to happen. It is good to know what you really own. Our clients have learned that getting two sets of statements is not a bad thing. People will try to cheat, but the old adage “cheaters never win and winners never cheat” exists for a reason. Insider trading is as old as stock markets themselves, but none of the legendary investors have ever been accused of it. In fact, distance from the Wall Street rumor mill has proven a positive thing more times than not. John Maynard Keynes and Warren Buffett both made their investing legends largely by making decisions in their pajamas, completely isolated from the clamor of the markets. Sir John Templeton claimed his investment results improved when he moved his office from New York to Nassau. Insider trading as a strategy turns out to be hugely overrated.
It may be raining, but history has taught us that we can still deliver competitive returns to our clients without any cheating. Don’t be discouraged by all the noise and headlines. The fundamentals look good. It certainly appears we are in the still-early stages of a prolonged bull market. We may continue to see three steps forward and two steps back progress, but the trend is upwards for equities. Our predictions for 2011 are forthcoming, but in the meantime you don’t need to worry about whether you can trust the markets or Wall Street because you know you can trust Iron Capital.
Happy New Year!
Chuck Osborne, CFA