This has been a tough year in the market. Thankfully, the rally we predicted in our October 3 Insight has occurred. We have seen negative results year-to-date even still, but it could be worse: you could have put your money with FTX.

For those who do not follow the financial news, FTX is (or, was?) a cryptocurrency exchange, which has collapsed. Client assets are frozen and possibly wiped out. I say possibly because no one really knows where the money is located. FTX’s new CEO is John J. Ray, who specializes in cleaning up bankrupt companies; most famously he was brought in to clean up Enron. He is on the record saying that FTX financial information isn’t trustworthy; in fact, he stated he has never seen anything as bad as this in 40 years of restructuring companies.

FTX’s former CEO, Sam Bankman-Fried, evidently did not see the need to keep records at all. Why would he? He is a 28-year-old wunderkind who had a crypto empire and was living a hedonistic life in the Bahamas in a polyamorous relationship with anywhere from seven to ten people, depending on which tabloid one reads. Who has time for bookkeeping? That is old-world stuff…he was enabling crypto, “the people’s currency.” It was a bold new world, until it wasn’t.

Needless to say, none of our clients had exposure to FTX (unless they did it separately without our knowledge). The last time I wrote about crypto in 2017, cryptocurrency enthusiasts were explaining that what they were really excited about was not a new form of currency, but the blockchain technology that makes crypto possible. That made no sense, since putting money in crypto wasn’t actually investing in blockchain technology, but at least they understood that a currency backed by absolutely nothing doesn’t make sense.

I wrote that article at the first height of crypto craziness, and crypto did in fact crash from there. Then the narrative changed at some point during the pandemic when people started talking about, and in some cases using, crypto as an actual currency. This is one of those “the emperor has no clothes” moments we seem to be having all the time now.

In the grand scheme of history, it has not been that long since the population of the world decided that we are comfortable with currency simply being backed by our faith in government. It wasn’t until 1971 that the U.S. dollar went off the gold standard for good. We did try to unlock the dollar from gold a few other times but were forced back to the gold standard for the dollar to be worth something. Since 1971, the dollar is simply backed by the faith and credit of the U.S. government (no wonder we have inflation).

Cryptocurrencies, on the other hand, are backed by absolutely nothing and nobody. Still people ask me if we invest in crypto, and my answer is that crypto isn’t an investment. We believe that an investment is just what Benjamin Graham said it was, “An investment operation is one which, on thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”

Graham spoke of investments needing a margin of safety – meaning they are backed up by something real: assets and cashflows. The crypto universe, like so much in our time, isn’t real. There will be many FTX speculators who are finding that out the hard way.

We don’t take pleasure in other people’s suffering, but it is Thanksgiving, and we have much for which to be thankful. In keeping with our tradition, here is my list:

-> I am thankful that we did not speculate in FTX.

-> I am thankful that my wife and I both believe in monogamy and didn’t even know “polyamorous” was a thing (maybe I’m getting old, but that sounds gross and exhausting).

-> I am thankful for our children, who are keeping my wife and me very busy.

-> I am thankful that my son has his learner’s permit and is just one year away from driving solo so my wife can quit her current role of unpaid chauffeur.

-> I am thankful for my family, immediate and extended.

-> I am thankful for all of my friends.

-> As always, I’m thankful for Mama’s pumpkin cheesecake and for my loose-fitting pants, which – while no longer in style – still make enjoyment of said cheesecake possible.

-> Finally, I am thankful for you, our clients and friends. Your trust in Iron Capital is our greatest asset and we value it every day of the year.

Happy Thanksgiving!

Chuck Osborne, CFA
Managing Director

~It Could Be Worse

The one thing I know about British politics is that if I ever get depressed about the state of U.S. politics, I can always pick up a British news story and feel much better. There is a long history here. They created a separate church so the heir-obsessed King Henry VIII could annul his marriages and behead his wives without spiritual condemnation. Is it any wonder we beat them twice, and then little more than a hundred years after the second beating had to save them from the Germans, only to have to save them again some 25 years later from, yes, the Germans again.

There are many lessons to be learned in the shortest run ever as a Prime Minister of Great Britain, and I’m sure there will be books written that will take longer to read than Ms. Truss’ tenure. We are going to focus on two immediate lessons that deal with economics and how markets work.

What got Truss into trouble was her reportedly aggressive tax-cutting schemes. Lesson number one is an economic policy lesson: tax reform is about reducing the government’s influence on the economy, not just cutting people’s taxes. Since the days of Reagan and Thatcher, every conservative politician in the world has preached tax cuts: “Vote for me and you will keep more of your money.” It is often said that what voters want is lots of government programs and no taxes; that doesn’t work so well in real life, but most politicians hope to be out of office before the bill comes.

Tax policy success is like everything else:  the devil is in the details. We seldom get details these days; we just get a declaration that the Truss government was going to cut taxes, usually with some added modifier like “ill-advised,” which makes the article more propaganda than actual news. I don’t know the details of the Truss policy proposals, but I do know a fair amount about what Reagan actually did in office. Reagan was far more of a tax reformer than an actual tax cutter. During his administration, Congress lowered income tax rates and reduced the number of brackets, but they also eliminated many tax shelters.

The biggest economic issue with tax policy is not usually the rate, but the impact of tax incentives on the economy. The big-picture goal is to reduce the influence of government on the economy, not necessarily to reduce one’s tax bill. In the real world, high tax rates are always accompanied by tax loopholes for the politically favored. In this way the government influences the economy, and usually that turns out to be a bad idea. Reform is not about reducing tax receipts; it is about reducing these incentives. My guess is that Truss, like many conservative politicians, oversimplified the lesson and just wanted to cut, then cut some more.

When the markets took a look at the Truss economic agenda, they saw deficits exploding in an already precarious fiscal situation. They reacted by doing what markets do best in the short term:  panic. The value of the pound plummeted and rates on British debt rose rapidly.

This brings us to lesson number two: markets anticipate. An important factor here that has not been reported, at least certainly not enough, is that Truss never actually did anything as Prime Minister. None of these recommended policies were voted on, and even things that did not need parliament’s approval had no chance to take effect. But markets don’t wait for the real-world impacts; markets anticipate, and by the time reality finally hits, they are anticipating the next thing.

This is probably the most important lesson to be learned here. The Biden administration’s first official act was to shut down the Keystone Pipeline and put a moratorium on oil and gas leasing activities in the Artic National Wildlife Refuge. Energy prices started to rise. A logical person could point out that the pipeline wasn’t finished, so it really didn’t change the status quo. One may point out the numerous existing oil leases that are not being drilled for various reasons. The same person could point out that “Trussenomcics” was all theoretical. None of that logic matters to markets.

Market anticipation isn’t always right, and that is what creates opportunities. The stock market this year has been anticipating a severe recession brought on by higher interest rates, yet in reality, in June and again this month, corporations are reporting results that indicate this isn’t happening. We should enjoy the rally while it lasts and hope the market has learned a lesson. We need to stay diligent, however, because today’s reality is not as important to the market as the market’s belief in tomorrow’s reality. Markets anticipate.

Warm regards,

Chuck Osborne, CFA
Managing Director

~The Lessons of Liz Truss

The third quarter ended poorly last week in what has been a very frustrating year for markets thus far. It begins to feel like it will never end. We are in a horrible cycle in which the Federal Reserve, and many in the markets, seemingly want a more severe recession. Every time corporate earnings or economic data suggest things are not as bad as they want it to be, they punish stocks. It seems like we are in a never-ending downward spiral.

It always seems that way right about when the market finally hits bottom and starts climbing. It is impossible to call such things, but this is feeling like a bottom. I would be very surprised if we do not rally from here – that may even be happening this week. The question will then be: Is this another bear market rally or is this one for real? Time will tell.

Meanwhile, times like this remind us to focus on the fundamentals. Prudent investing is done from the bottom-up, and the companies we own – both directly and indirectly through funds – are high-quality companies. I couldn’t be writing this without products from Microsoft. Apple keeps me connected when I’m away from the office. Most of us are still putting gas in our cars, and we all need food on the table.

Market and economic cycles are part of life. This too shall pass, and we will be glad that we were able to buy these companies at these prices. It may not seem like that now, but it is always darkest before the dawn.

Right now, our thoughts and prayers are with those who were impacted by Hurricane Ian. I was in St Simons Island, GA, the weekend before Ian, and was reminded that it is always beautiful right before the storm comes. When the storm leaves, there is damage to be handled, but it is almost eerie how beautiful the weather gets.

Whether in real life or in our financial lives, storms can be unnerving, but they do pass. Right now may seem bleak, but it is time to stay the course. Dawn will come.

Warm regards,

Chuck Osborne, CFA
Managing Director

Authored 10 a.m. Monday, October 3, 2022

~Darkest Before Dawn

“The difficulty lies not so much in developing new ideas as in escaping from old ones.”  ~ John Maynard Keynes

Federal Reserve Chairman Jerome Powell assured us last spring that inflation was transitory. At the time, we suggested that perhaps transitory didn’t mean what he thought it meant. Now he is telling us that inflation must be crushed through pain. He was wrong then, and he is wrong now.

It is as if Mr. Powell, his fellow Fed governors, and the approximately 400 doctorates who work for the Federal Reserve are all fit with blinders. They didn’t see the growth in money supply, or the high energy and food prices, or the incredible increase in housing cost. They could only see short-term supply issues caused solely by our reaction to the COVID pandemic. Those were temporary; therefore, inflation was transitory. They were blind to all the more lasting drivers of inflation, and as a result, they were late in addressing it.

They finally did address it, however, and have now raised rates from 0.25 percent at the beginning of 2022 to 3.25 percent. That is a substantial increase in a short period of time. The impacts of these raises have not even had time to work their way into the economy. Meanwhile, the drivers of inflation that the Fed missed on the way up, are now all on the way down. Money supply, energy prices, and housing are all in declines. The price of oil went below $80 a barrel on Friday for the first time since January. They were blind on the way up and now they are blind on the way down.

They seem to have it stuck in their heads that the only way to beat inflation is to cause a recession. Guess what? We are already in a recession. We have had negative GDP growth for two quarters in a row. The Fed is predicting the GDP growth for 2022 will be 0.2. To achieve that, we would have to grow the second half of this year at a rate of more than 2 percent. Based on where we are now and in light of the Fed’s actions, that is so overly optimistic it is laughable.

Powell, and many other pundits, keep saying we are not in a recession because the labor market is still strong. I understand that; the labor market has long been our indicator as well. It was weakness in the labor market that made us predict a bear market in 2008, although we had no idea it would be as bad as it was. However, it isn’t always the same. We have had two quarters in a row of negative growth; that is a recession. Inflation is coming down; there is no need to make things worse.

If you have not seen it, I would recommend watching the CNBC interview with Jeremy Siegal[1]. Mr. Siegal, economist and professor of finance at the Wharton School, sums up the frustration we all have with the Fed.

Unfortunately, the Fed that was blindly focused on pandemic supply issues seems now to be blindly focused on employment and wages. They believe that they cannot truly cure inflation unless they drive unemployment up and wage growth down. This is an old idea, and in fairness it has some merit. However, there are new factors that they seem to miss: Although unemployment is low at 3.7 percent, we still have a full 1 percent decline in the labor market participation rate from pre-pandemic. If that 1 percent were to rejoin the labor market tomorrow, then unemployment would be 4.7 percent – three tenths of a percent higher than the Fed’s target of 4.4 percent. We have a worker supply problem, not a job demand problem.

Their other focus is on wages. Wages are rising, but that is not driving inflation, it is lagging behind inflation. Real wages are and have been dropping. You don’t need me to tell you that – every person we talk to is talking about budgets being strained, not wallets being flush.

If I had any hair, I would be pulling it out. But, we must play the hand we are delt. We are making moves to position portfolios as best we can. The silver lining of higher interest rates is that bonds are beginning to look attractive once more (and I did have hair the last time I could honestly say that). If Powell gets his wish and our current mild recession becomes a more severe recession with global implications, investors will look for quality, and most of that is here in the U.S.

It has been a rough year mostly due to poor policy, and it may now get worse due to even more poor policy, but it will pass. It will indeed be morning again in America at some point. Bear markets create opportunities for long-term investors. We will get through this.

Warm regards,

Chuck Osborne, CFA
Managing Director

[1] This video is available via CNBC Pro with a 7-day free trial. As an alternative, Mr. Siegel reiterates the same position in this clip from “Squawk Box” 09/26/22

~Blinders

You have heard of the madness of crowds… on Tuesday this week, we witnessed the madness of computers. A few years ago, we talked quite a bit about the phenomenon of computer-driven trading. We don’t think of it much anymore, but it is still there, and every once in a while it rears its ugly head.

Tuesday’s Consumer Price Index (CPI) report showed inflation at 8.3 percent – below the previous reading of 8.5 percent, but above the expectation of 8.1 percent. The core reading, adjusted for food and gas, came in at 6.3 percent, which was an increase. The driver on that increase was housing, and it is important to understand that the current methodology for calculating housing cost has an almost seven-month lag. Real-time data suggests that housing has peaked and is heading down in price.

Here is where the computers take charge: They were programed for “miss on inflation = sell.” Had inflation been lower than the published expectation, they likely would have bought. How do I know this? In truth I have no evidence, nor am I going to waste my time researching, as it really doesn’t matter. Logic and experience tell me that no thinking human being with even a modicum of financial sense is hitting the panic button over an inflation reading that is headed in the correct direction – only computers trade like that.

Economic forecasting is not an exact science; in fact, it can barely be called a science at all. The important factor in Tuesday’s number is not whether it is 8.1 vs 8.3. The important factor is that this is the second reading in a row that is heading down instead of up. Thus far inflation, as measured by CPI, has peaked at 9.1, and the next two readings have been 8.5 and now 8.3. That is good news, not bad.

The sudden selloff does reflect the mood. Pessimism is high right now – too high, in our opinion. Pessimistic short-term traders create opportunities for long-term investors. We don’t even need things to be good, we just need them to be not as bad as the pessimists believe. An inflation reading of 8.3 percent is certainly not a good thing, but it is better than 9.1 percent and better than 8.5 percent. Improvement is all we need. Keep it heading in the right direction.

I know it is frightening to many to see the stock market go down 4 percent is a single day. When it happens, it is important to remember that this does not reflect reality. Apple is not a different company today than it was on Monday. The Home Depot will not be shutting down anytime soon. Your Visa card will still be accepted when you need to use it tonight. The real world doesn’t change 4 percent in one day.

This is why prudent investing is done from the bottom-up. We are investors in companies not traders of stocks, and the companies we own, both directly and indirectly through funds, are doing well. To the extent that their business is hurt by inflation, that pain is a little lower this month than it was last. That is what Tuesday’s report says to a rational human being. The computers are frustrating, and can cause havoc in the short term, but in the long run it is still about the companies one owns. This too shall pass, and long-term owners will be rewarded.

Warm regards,

Chuck Osborne, CFA
Managing Director

~The Madness of Computers