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.
On November 11, 1918, in the French town of Compiegne, the Allies and Germany negotiated cessation of hostilities on the Western Front effective at 11:00 a.m. Paris Time. At the eleventh hour on the eleventh day of the eleventh month, the War to End All Wars was over. Armistice Day, celebrated throughout the western world,…
What happened to the European debt crisis that caused so much market turmoil in August and September? What happened to the slow U.S. economy and mountain of government debt that caused the U.S. credit rating to be downgraded by Standard and Poor’s? To my knowledge nothing has happened to fix these situations, but don’t tell…
The third quarter of 2011 was the worst quarter for investors since 2008. You are going to hear that scary phrase a lot, so brace yourself. This is one of those times when I would like to swoop in with all kinds of good news and prove that things are not as bad as they…
John Maynard Keynes is known by most as a famous economist whose creative ideas on smoothing out the rough edges of the business cycle have proven repeatedly not to work. However, during his life he was also a money manager and one of the greatest of all time. His ideas on investing have influenced many,…
Our world, and by extension the investment markets that are a reflection of our world, seems to be suffering from a serious case of over-specialization. The advice most often given to the last generation of workers and professionals was to learn all one could about one thing. Become an expert in your field. This is…
On November 11, 1918, in the French town of Compiegne, the Allies and Germany negotiated cessation of hostilities on the Western Front effective at 11:00 a.m. Paris Time. At the eleventh hour on the eleventh day of the eleventh month, the War to End All Wars was over. Armistice Day, celebrated throughout the western world, was a time to remember those who made the ultimate sacrifice in fighting against the Central Powers of Europe to defend our freedom. After World War II, the United States changed the name of the holiday to Veterans Day and expanded its purpose to celebrate not only those who fought the Kaiser, but also all American veterans who have fought to maintain our freedom.
It is somewhat ironic that we celebrate this Veterans Day, 11.11.11, just a few days after the German Chancellor has made a call for a “New Europe” and the world is once again threatened by European excesses. This time there has been no cannon fire, no battalions have marched, and no tanks are in the streets of Paris, but the lack of fireworks does not change the overall script. Sure, there are differences — Germany likes to change dance partners from time to time. In World War I it was the Central powers of Austria-Hungry and the Ottoman Empire, while in World War II they preferred the Axis powers of Italy and Japan. Today it is France and the Euro Zone, strange as that may seem. The goal is, however, the same: to control the whole of Europe in the name of centralized governmental power. If successful Germany yet may get the European dominance they seem to have wanted since the day their barbarian ancestors destroyed what was left of the Roman Empire and cast the world into Medieval darkness. If they fail, Europe will once again be trying to piece itself together in the aftermath of another ill-fated attempt to bring the continent under central control.
This saga, while gripping, is wreaking havoc with the financial markets. We foresee one of two outcomes: Germany could get its way, with a much stronger Eurozone that would not only determine a country’s currency but also would have great control over fiscal policy; or the Eurozone, and possibly the entire EU, will collapse. Either scenario could work in the long term, and it is not our place to judge which is best, but getting to either point is going to be politically painful, and that political pain will continue to spill over into the markets. We will see up days, even short rallies, but it is hard to see how our markets go up with an economy the size and importance of all of Europe in such a political mess.
The collapse of Greece has been distracting markets for more than a year. Greece is much like the sub-prime mortgage market — alone neither was big enough to really cause pain, but they were not alone. The mess in sub-prime was actually in the whole mortgage market, just as the mess in Greece is in all of Europe. Sub-prime and Greece were simply where the problem was at its worst and therefore were the first dominos to fall. Italy is now the concern. Italy has the world’s third-largest bond market, behind the U.S. and Japan. This makes Italy too big to be bailed out and a real threat to the global economy.
The mortgage mess was really just a symptom of larger issues, and this debt crisis in Europe is just the same. In our case it was the must-have-it-now, free-spending culture that caused people to buy houses they could not afford, financiers to sell mortgages that should not have been sold, and elected officials and regulators to push for more home ownership. In Europe the issue is the entitlement culture that sees work as a distraction from life instead of a meaningful part of who one is as a person. Europeans have been far too comfortable with the regulatory nanny state and the unsustainable social contract that goes with it. Sacrificing freedom for a false sense of security may feel better than being subjected to a tyrant, but in the end neither is sustainable. People are meant to be free.
This brings us back to the purpose of this day. As we honor those who have fought to keep us free, let us not forget that freedom is worth fighting for, and that freedom is what has made this country great. Regardless of whether one chooses to use freedom to work on Wall Street or occupy it, or to go to tea parties or ridicule them, one owes that freedom to the men and women who have served this country in its Armed Forces.
Today the entire Iron Capital family solutes all veterans of the U.S. Armed Forces and thanks you for protecting our freedom. May God bless you, your families and the United States of America.
Chuck Osborne, CFA
~The 11th Hour, of the 11th Day, of the 11th Month
What happened to the European debt crisis that caused so much market turmoil in August and September? What happened to the slow U.S. economy and mountain of government debt that caused the U.S. credit rating to be downgraded by Standard and Poor’s?
To my knowledge nothing has happened to fix these situations, but don’t tell that to the stock market. Stocks have gone on a tear in the month of October and seem to be shrugging off all the worries that had caused them to go down so far in September. This seems to be the manic phase of the manic depression we have been in for more than a year now. In the interim, all hopes seem to be resting on what the European leaders do on Wednesday.
For those who need some catching up, European leaders have issued a self-imposed deadline of Wednesday to bring forth a plan to finally bring their debt crisis to an end. Of course they already did that three months ago, or so we were told. This brings us to a large disconnect: the European bond market is pricing in failure as the spread has widened considerably between the “safe” German Bund and the rest of Europe – including countries like France, not just Greece and the other so-called PIIGS. This tells us the bond investors think there is a likelihood of a Europe-wide recession.
The stock market, especially our stock market, seems to be ignoring such inconvenient news. Of course there have been some positive earnings announcements, but we have had those all along. There have been some merger and acquisition announcements, but that is not out of the ordinary. I think most of this rally is based on the hope that Europe actually will have a real plan come Wednesday. Certainly that is possible; it could happen, and if it does, that would dramatically change the outlook on our economy and the stock market over the short run.
But how likely is it? The bond investors in Europe are telling us it is not likely at all, which brings me to a realization I made about 15 years ago. That was the first time I sat down with some former PIMCO analysts who were starting their own firm. I was blown away; these were the smartest people I had ever met in my life. This is a bold statement, since I have been blessed with fantastic educational experiences and have been surrounded by very smart people all my life. These guys were, to be flip, wicked smart.
When we left that meeting my colleague and I were both impressed. My colleague was a former college professor with a PhD – he himself was no idiot. I told him I thought these were the smartest guys I had ever met, and he responded, “You have to be smart to manage a bond portfolio. Any idiot can pick stocks, but the bond guys are smart.” No truer words have ever been spoken.
Perhaps the stock market is correct and come Wednesday the worst financial crisis since the Great Depression will just be over, Europe and the rest of the world will go on to prosper, and stock prices will climb to the sky. Or, perhaps come Wednesday, or some time thereafter, we will be reminded that this crisis in Europe is far from over and that the risk of global recession is very high.
The wicked smart guys are betting on the latter. They could be wrong, it is possible. The stock market seemingly sees no evil on the horizon, hears no evil on the horizon and speaks no evil on the horizon. It would be great if the stock market were correct, but until the smart guys agree I think it is prudent to remain defensive.
Chuck Osborne, CFA
~See No Evil, Hear No Evil, Speak No Evil
The third quarter of 2011 was the worst quarter for investors since 2008. You are going to hear that scary phrase a lot, so brace yourself. This is one of those times when I would like to swoop in with all kinds of good news and prove that things are not as bad as they seem. There are silver linings: stock valuations are the best they have been in a generation. Corporate results have been strong and their stocks are selling at bargain-basement prices. This most probably will prove to have been a great time to be buying stocks when we look back a decade from now. It sure does not feel that way now, and most likely it won’t in the near future.
We have spoken frequently this year about the dichotomy between the bottom-up attractiveness of so many equity investments, and the top-down gloom of our geo-political situation and the overall economic malaise this situation has delivered. In third quarter it was the latter that dominated the stage, and as a result we have seen a rapid drop in equity values.
The headline-grabbing Dow Jones Industrial Average was down 11.49 percent while the often-quoted S&P 500 was down 13.87 percent. Unfortunately these popular benchmarks paint a rosy picture on what really happened: small-cap stocks were down 21.87 percent while German stocks were down 25.41 percent and Hong Kong saw a 28.99 percent drop.
All of this is most likely an overreaction to a global economic situation that is probably better than most believe. Unfortunately, this overreaction can become a self-fulfilling prophecy. The volatility of the market itself can cause pessimism, and pessimism can cause a recession. The odds of slipping back into recession have increased significantly; today I would give it a 50-50 probability. Three months ago I thought the odds were slim.
Even if the U.S. manages technically to avoid a recession, we are still back at one to two percent GDP growth, which may be a distinction without difference. To us at Iron Capital this means the odds of continued downturn are significant. Let me say it again: it is time to brace yourself. Now is the time to be honest about how much risk you are willing to take. For some of you third quarter alone has gotten you to that point, while for others it will take more pain. Now is the time to make those decisions, not after the recession is here and the market is down another 20 percent.
Investing is not complicated. It is no more complicated than losing weight. In the latter you simply have to eat less and exercise more, and in the former you simply have to buy undervalued securities and wait until their value is recognized. These are not complicated things to do, but they are among the most difficult challenges we all face.
We are here to help. We are doing what we can to protect in the short-term while remaining focused on the long-term. Today that means we are bracing ourselves.
Chuck Osborne, CFA
John Maynard Keynes is known by most as a famous economist whose creative ideas on smoothing out the rough edges of the business cycle have proven repeatedly not to work. However, during his life he was also a money manager and one of the greatest of all time. His ideas on investing have influenced many, and some would argue that he invented the concept of the hedge fund. I tell you this because regardless of your thoughts about his economic ideas, I believe his thoughts regarding the market are worthwhile.
One of my favorite Keynes quotes goes as follows, “Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.”
It certainly feels like Keynes’ prophetic warning has come to pass.
The public markets have become hostages to so-called high-frequency trading (HFT) firms. These are organizations that trade stocks through computer programs at a rate of speed not before fathomed. It is literally possible for these firms to “own” a stock for no more than a few seconds. This is speculation run amok and they are harming our market, and as a result the allocation of capital in our society, and ultimately job creation and the economy as a whole. They need to be stopped.
It is important to understand why this is such a problem today. The stock market has always been home to a certain number of speculators; today they like to be called traders, but I prefer the more accurate title along with the deserved negative baggage. Having said that, speculators do serve a purpose, and they will always remind you of this. They provide liquidity. Long-term investors can buy and sell when they wish largely because there is always some short-term speculator willing to be on the other side of a transaction. Speculators can even provide opportunities for investors as they create dislocations in the market, beating up stocks to the point where they present great long-term opportunities for gain. Besides, speculating can be fun. We all have a little speculator in us. This is part of the lure of Wall Street to so many young professionals. (Experience usually takes away some of that luster; after all, Las Vegas was not built on gamblers’ ability to win.)
Historically, and not that long ago, speculators were held in check because theoretical profits of various rapid-trading strategies were destroyed in reality by taxes and transaction costs. This has changed. The automation of trading has made it so cheap that small profits can be made holding stocks for seconds. What this has done is ramp up the volatility to places I have never seen in my career. Much of it is just stupid.
One recent example can be found in the stock of Express Scripts. Express Scripts is a pharmaceutical benefits company – the people who pay for your prescription drugs. A well-known analyst lowered his price target on Express Scripts from $64 to $60, and the stock went down almost three percent that day. On the surface this may make sense – an analyst lowering the price target is not a good thing. However, the intrinsic fact being ignored is that Express Scripts was trading at approximately $43 when this announcement was made, so the analyst believes the stock is going to go up almost 50 percent. No human being would see that message as bad, but to a computer program that operates by a rule – analyst lowers target = sell – that is a different story. During the extremely volatile week of August 8, an estimated 80 percent of market volume was attributed to computer trading. The flash crash of last May was attributed to the same issues.
This volatility is keeping real investors out of the market. In fact I believe the old argument for speculators creating liquidity has fallen apart. By keeping investors away these HFT firms are actually destroying liquidity. Total volumes in the market are still below their 2007 highs.
The SEC is trying to do something about it. They are creating a trading auditing system named CAT that will help them monitor the actions of these HFT firms. The firms are pushing back. I don’t know if this auditing system will be the answer but it certainly will help. The added cost in trading alone will slow these firms down.
I have a better solution. Most of the money that floats around on our exchanges actually belongs to institutional investors – pension plans, endowments, foundations, and your retirement accounts. This money is all tax-exempt. In addition, hedge funds that consider themselves traders and not investors are given tax advantages. The bottom line is much of this extreme short-term speculation goes on because none of the practitioners have to factor in taxes. This means it makes no difference to them if their profits are from short-term trading or long-term investing. My suggestion is to take away the tax exemption for short-term capital gains for otherwise tax-exempt institutions. It wouldn’t take a week for every institutional investor in the country to pull every dime they have given to the short-term trading firms.
I am a big believer in free markets. It is usually the rules, not the freedom, that cause problems. In this case the rules – tax exemptions and tax breaks – have actually unintentionally encouraged speculation over investment. It is time to correct that. Creating an audit trail and/or paying a tax will not eliminate speculation, nor should it. It may, however, put it back in its place, as the bubble on the steady stream of enterprise.
The rapid-trading firms are a small, cohesive group with a lot of money, which gives them a great political advantage over the masses of investors who would benefit from their being constrained. I urge each and every recipient of this message to reach out to their elected officials and tell them you wish to encourage investment and discourage speculation. Remind them that capitalism is not about trading, it is about capital flowing to real companies that produce real products and in so doing, create real jobs.
Chuck Osborne, CFA
~A Hidden Menace
Our world, and by extension the investment markets that are a reflection of our world, seems to be suffering from a serious case of over-specialization. The advice most often given to the last generation of workers and professionals was to learn all one could about one thing. Become an expert in your field. This is logical advice, but, like anything in life, when taken too far can cause problems. In becoming experts on singular issues we seem to have lost focus on the big picture. What we need in our world today is what they used to call a “Renaissance Man,” someone who was truly educated and knew about a great many things. Someone who can see the forest and not just the trees.
What does this have to do with our current investing environment? Everything. It seems we live in a world where investors and policy-makers alike do not seem to understand the consequences of their actions on other parts of the world. Our world is one big living organism, it is not a series of specialized silos. The only way to see the truth – the whole truth – is to understand the big picture.
Last week the federal government announced that it was suing the 17 largest banks for “their part” in the financial crisis. Today there is an article in The Wall Street Journal suggesting that one of the largest obstacles to a robust recovery is the inability of so many homeowners to refinance and actually take advantage of these historically low interest rates. In our specialized world people seem to read these as two unrelated items, yet they are not: a bank being sued for being too aggressive in their lending practices is going to react by not lending.
Investors are acting just as recklessly. A few weeks ago I received a newsletter from one of our competitors in which they were claiming that inflation was coming, justifying their large allocation to commodity investments. They, along with so many others like them, caused a spike in commodity prices. When that happens in an environment that is not inflationary – as we discussed in our latest “Quarterly Report” – it leads to an economic slowdown. Friday I received another newsletter from the same firm saying that we are heading for a Japanese-type stagnation; however, there was no admission of their role in causing such by artificially boosting commodity prices.
Nowhere is this dangerous lack of focus on the big picture more disturbing than in Europe. Every time the EU tries to solve a debt crisis fire with a band aid, simply kicking the can down the road, the bigger the next fire becomes. The EU needs to take decisive action one way or another to bring this crisis to an end. Allow Greece to exit the EU and default on their debt, or take their debt over completely. Until then we are going to continue to see market turmoil. European markets are down approximately eight percent over the last two days.
The markets will be watching the President’s speech on jobs this week. Hopefully there is a realization that all actions of government affect jobs. Health care, financial reform, wars, tax reform and the debt crisis – these are not isolated issues, one different than the other. They are all parts of the bigger picture, one that has been incredibly bad for jobs and that increasingly is risking a new recession.
Another part of that big picture is the actual health of the corporate world. Corporations are not lowering their forecasts. In August only 138 companies lowered their earnings forecasts, while the norm over the last decade has been an average of 221 lowering forecasts. If you split the world into three segments, governments, consumers and corporations, corporations are in the best shape by far. Unfortunately, the market is ignoring this third of the forest, even though it is the third where your money is actually invested.
This leads to a frustrating environment where the opportunities for future returns look very attractive, but the immediate concerns over government balance sheets and the hard politics that go along with this situation increasingly are causing the consumer to grow pessimistic. The end result is volatility. The longer this volatility lasts, the greater the probability of a severe bear market.
I am not saying this is a foregone conclusion; in fact we remain cautiously optimistic over the next two to three years, but the odds of a severe bear market are increasing. What we need is some well-rounded, big-picture leadership from policy-makers who consider the whole truth. Unfortunately we seem to be surrounded by specialists. Alas we must play the cards we are dealt. We will continue doing all we can to protect your assets in this environment.
Chuck Osborne, CFA
~The Truth, the Whole Truth, and Nothing but the Truth