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.
Volatility is back in a big way. Since the downgrade of U.S. debt by S&P, the equity markets have been swinging wildly. There is a sense over the last few days that we have finally gotten past all of this as positive momentum has taken over, but I’m not so sure. We are investing in…
Standard & Poor’s (S&P) has downgraded U.S. Treasuries to AA+ from AAA. While this has been discussed for several months, the announcement yesterday evening came as a bit of a surprise. The question is, what does this mean for you? The truth is that I am not really sure, and neither is anyone else, regardless…
I often wonder, what is the person on the other end of this transaction thinking? One of the best investment books of the last decade isFooled by Randomness, by Nassim N. Taleb. Taleb, an options trader by profession, does an excellent job of explaining how humans are hard-coded to find patterns, even when patterns don’t…
As the debt ceiling debate drags on we are faced with some tough decisions from an investment standpoint. The medical profession has a standard often expressed in the Latin phrase “primum non nocere,” which translates to, “first, do no harm.” According to the omniscient Wikipedia, it is a fundamental principle for emergency medical services around the…
I have put off discussing the debt ceiling for two reasons. First, because these economic issues are inherently political, and I promised not to discuss anything political this year, since I don’t like doing it and was tired of having to do so for the last few years of the economic crisis. Second, the market…
Volatility is back in a big way. Since the downgrade of U.S. debt by S&P, the equity markets have been swinging wildly. There is a sense over the last few days that we have finally gotten past all of this as positive momentum has taken over, but I’m not so sure.
We are investing in the midst of a split reality. On one side you have governments throughout the developed world that have spent beyond their means. It is easy to make promises when times are good and you are running for re-election. Who doesn’t want their retirement funded, or healthcare provided? Who doesn’t want their taxes reduced or homes subsidized? All of this is easy until the bills come due.
The bills have arrived for Greece, Italy, and the rest of southern Europe. This has highlighted the fact that our bill is on the way, and it is going to be a doozie. Our politicians seem more divided and partisan than ever, people are anxious, and S&P says the U.S. Treasury bill is more risky than the mortgage-backed securities that started this whole mess almost four years ago.
However, on the other side of this split reality we have corporate America. Here most things are actually good. Every quarter it seems that corporations report better earnings than expected. Revenue has been growing year-over-year. Balance sheets are strong and the prices are right for long-term investors.
So it’s really just a matter of on what one wishes to focus: If we focus on fundamentals of the companies in which we are investing, the market is up three to four percent that day. If we focus on our national debt and our political environment, the market is down three to four percent that day. This volatility is why we have taken steps to reduce the risk in our portfolios, while simultaneously looking for opportunities.
This environment is stressful, and unfortunately it is not over. It probably will not end until the debt crisis is actually addressed. Thus far in most of the developed world, politicians have played kick the can: they apply one Band-Aid after another, thinking that if they can just postpone the inevitable for a few more months things will get better. That is wishful thinking.
In Europe the EU needs to do one of two things: get weaker, by allowing the troubled countries to get out and fix their own mess; or get stronger, by issuing Euro bonds and taking over the debt of troubled economies. Today I believe the latter to be the highest probability. The longer they wait to end this crisis by taking one of those radical steps, the longer we will be on this rollercoaster.
Domestically, we need a coherent direction. We all have our own political feelings and opinions on what that direction should be, but in terms of investing, which direction isn’t as important as having a direction – any direction. We now seem rudderless.
The story goes that Mark Twain and novelist William Dean Howells stepped outside one morning, a downpour began, and Howells asked Twain, “Do you think it will stop?” Twain answered, “It always has.” It may take a while, but this malaise will pass. When it does, investors should once again focus on the actual investments. When that happens we should be ready for a long bull run.
Chuck Osborne, CFA
~This Isn’t Over Yet
Standard & Poor’s (S&P) has downgraded U.S. Treasuries to AA+ from AAA. While this has been discussed for several months, the announcement yesterday evening came as a bit of a surprise.
The question is, what does this mean for you? The truth is that I am not really sure, and neither is anyone else, regardless of how confident they may sound about their theory. This has never happened in the U.S. and no one really knows exactly what is going to happen. I can tell you that Iron Capital’s investment committee is going to meet via teleconference Sunday evening and again very early on Monday morning. We will determine what, if any, action is appropriate and be ready to act when markets open.
In the interim I can shed some light into the real issues at hand here. Let me start by reminding everyone that credit rating agencies’ opinions are exactly that, opinions – nothing more, nothing less. S&P has just announced that it is their opinion that U.S. Treasuries are not as safe as they once were. We have been announcing that opinion for two years now. Someone stating their opinion does not actually change reality. The U.S. government is not more likely to default on their debt today then they were yesterday, before the downgrade. Unfortunately, while downgrades don’t change reality, they can shift the perception of reality, and that may be more important.
The textbook response to a downgrade would be a sell-off in the bond market as people sold the downgraded securities, which would result in higher interest rates. Undoubtedly you will be hearing about the dangers of higher interest rates from media talking heads. This is certainly a possibility; however, recent bond market behavior would indicate that this is not likely. On June 30, the ten-year Treasury had a yield of 3.22 percent. At yesterday’s close that yield was down to 2.56 percent. That lower yield means a higher price, and that means investors have been buying Treasuries like they are going to stop printing them. This has happened while the biggest financial story of the last month has been the debt ceiling and the possible default and downgrade of Treasuries.
You all should know this, as I have been writing ad nauseum about the irrational behavior of the bond market. If the threat of default didn’t make interest rates rise, a downgrade may not either. In fact, Japan has been downgraded regularly over the last decade and a half or so, and they still have very low interest rates. However, there is a danger that some institutional investors may have to sell.
One of the biggest problems in the institutional investment world is rules-based investing. Too many plan sponsors think they can protect themselves from poor judgment by replacing judgment with rules. Nowhere is that more prevalent than in the investing of bond portfolios. Several states have even gone so far as to legislate rules into the state code for public pensions. This was a major contributor to the financial crisis and one that has not been addressed. Many pension plans will be forced to sell Treasuries, even though they may not want to, unless they can get these rules changed.
The credit rating agencies should have never been given that much power. Their ratings are no more meaningful than the buy or sell ratings of Wall Street analysts in the equity world, as was evidenced by the AAA rating of mortgage-backed securities. No one would ever write an investment policy that limited equity portfolio managers to stocks that had buy ratings, yet the industry does it all the time in the world of bonds. This practice needs to stop, and investors need to use their own judgment and conduct their own research. All the bond managers we use and recommend already do this.
There is probably time to get these rules changed as S&P is only one rating agency and the rules don’t usually state which rating agency the investors have to use. The selling may be less than expected because Moody’s and others still have the U.S. at AAA. However, since S&P has downgraded, the others will likely follow soon. If these rules can be changed, then drastically higher interest rates and a route in the bond market may be avoided.
Theory would also suggest no reaction in the stock market as this downgrade does not directly impact stocks. However, the stock market tends to be emotional and it is already at a low ebb. Some think the downgrade is already priced in, while others are sounding alarm bells. Either way, this is short-term. It has the potential to turn this correction into a bear market, or it could be nothing, but it will be the fundamentals of the actual companies – not the U.S. Treasury – that determine the long-run results in the stock market.
We know that news like this is scary. The media only make it worse, since they don’t want you to turn the channel. The first step in scary situations is to not panic, and I can assure you we will not do so. We are on top of the situation and will take defensive measures if necessary.
Chuck Osborne, CFA
~S&P Downgrades U.S. Treasuries: Now What?
I often wonder, what is the person on the other end of this transaction thinking? One of the best investment books of the last decade isFooled by Randomness, by Nassim N. Taleb. Taleb, an options trader by profession, does an excellent job of explaining how humans are hard-coded to find patterns, even when patterns don’t actually exist. Part of this is a need to know why. For example, why was the market down yesterday? The news will always give you a reason, and as Taleb points out, the reason they give is usually wrong and often just complete nonsense.
For the last several weeks the reason for negativity was the debt ceiling debate. Based on market activity over the last few days, I think a few people perhaps missed the memo: that crisis is over, Congress struck a deal. While some seem to be unaware of that development, the financial media is not among them – they have moved on, first to the bad U.S. economic data and then to Europe. I am not buying it.
I think the explanation for recent market fall is far simpler: over the last week or so there have been more sellers than buyers. That is it. Sellers outnumber buyers, thus, prices are going down. This leads to two questions: first, why aren’t there more buyers? In the midst of all the gloom and doom we have seemed to lose track of the fact that 77 percent of S&P 500 companies have outperformed on their earnings, and the S&P 500 is selling at approximately 13X earnings, which is very attractive. When you start breaking it down further there are bargains everywhere. Yesterday I read a headline that says that Berkshire Hathaway is selling for less than 2X the earnings of its operating companies. These are ludicrous valuations.
There are only two reasons I can think of for the lack of buyers. First, it is summer and who wants to buy stocks when it is this blazing hot. I am only half joking here. This is prime summer vacation time, and investors go on vacation just like everyone else. Second and more importantly, there seems to be a greater deal of uncertainty than usual for what the future is going to hold, illustrated by the drastically changing economic forecast. While we at Iron Capital have stayed fairly steady with a two percent forecast for GDP growth, we have been the exception. Most forecasts have gone from overly optimistic to overly pessimistic and back more rapidly than I can remember at any time in my career. The truth is reality does not change as rapidly as market prices and economists’ moods.
Although we remain cautiously optimistic on the equity markets, I do understand why more investors are not buying right at this moment. However, that leads us to the other side of the equation and our second question: who in the world is selling on a day like yesterday and what are they thinking? Based on information that we have thus far, the selling is not as heavy as the headline drops in the market may suggest. The few sellers are just selling into a vacuum. With no buyers out there to speak of, the sellers are selling no matter the price and making the market move lower than it really should. The only reason I can think of to do such a foolish thing is panic. Of course panic is by definition not a rational emotion, but I still have to ask, why are they panicked?
Sure, there is a long laundry list of things that are wrong with the world, but please point out one of those items which has not been on that list for months now, if not years. The financial condition or value of a company does not change much from day to day, and neither does the economic health of a nation or the world. Moods change quickly and market prices change quickly, but reality changes very slowly. There is nothing wrong with the world today that wasn’t wrong with it two months ago, when market prices were higher.
This environment creates opportunity for those who stay focused on reality and avoid the mood du jour. That is what we try our best to do at Iron Capital. Nothing changed from last week that would suggest this is anything other than a short-term market correction, and timing corrections is not a winning strategy.
Chuck Osborne, CFA
~Who Is Selling on A Day Like Yesterday?
As the debt ceiling debate drags on we are faced with some tough decisions from an investment standpoint. The medical profession has a standard often expressed in the Latin phrase “primum non nocere,” which translates to, “first, do no harm.” According to the omniscient Wikipedia, it is a fundamental principle for emergency medical services around the world. Another way to state it is that “given an existing problem, it may be better not to do something, or even to do nothing, than to risk causing more harm than good.”
We apply the same principle here at Iron Capital. Over the last several days we have spent considerable time, energy and effort in discussing the possible scenarios in this debt debate and how we should best protect our clients. In every scenario, we ask: what if we are wrong?
We have considered shorting Treasuries. This is, after all, the source of the problem. If Treasuries are downgraded or worse yet, go into default, they should lose value rapidly. To a large extent this should already have occurred and it has not. Some have even suggested that the dominance of the thoughtless risk-on/risk-off traders could even cause Treasuries to rally, since the panic over their downgrade would cause people to sell stocks – even though they are not directly impacted – and buy Treasuries – even though they are the problem. I know it is insane, but it is also a reasonable probability given the recent market behavior.
Another probability is that we do get a deal (by the way this is the highest probability) and the announcement of the deal causes Treasuries to rally. If either of those scenarios plays out, shorting Treasuries would have done more harm than good, not what we want.
We have considered shorting the stock market. The issue here is that a rally is likely when a deal is announced, and while not an absolute certainty, a deal is the highest probability. There is also the factor that many stocks look very attractive now from a fundamental standpoint. If politics were not a concern, we would not be considering shorting. It is uncharacteristic for the CNBC talking heads to make any good points, but one did yesterday when he commented that portfolio managers are good at analyzing fundamentals of companies and identifying long-term investment opportunities; they are not good at figuring out what a bunch of politicians are going to do. I would humbly include the professionals at Iron Capital in that description. We could do more harm than good.
We considered going to cash. The problem with going to cash is that you have to know when to go back. Returns in the stock market come in bunches. If you miss even one really good day, your long-term results will not be nearly as good as the person’s who stays invested. If we saw a prolonged bear market coming it could be a different story, but that is not the case. Bear markets are all about price-to-earnings ratios; one of those things has to collapse. In the tech bubble it was the price, and in the Great Recession it was the earnings. Today neither of those things seem to be occurring. This is more of a short-term phenomenon caused by political anxiety. Timing that is beyond our skills. Once again, we could do more harm than good.
So what are we going to do? We are going to wait and see. Sometimes that is the right and most courageous thing to do. We will be prepared to act should events transpire that shed more certainty to a potential prolonged bear market, but in the interim we will trust in the long-term supremacy of fundamentals over the short-term macro-economic noise. That has never let us down before, and it is unlikely to do so this time.
Chuck Osborne, CFA
~Primum Non Nocere
I have put off discussing the debt ceiling for two reasons. First, because these economic issues are inherently political, and I promised not to discuss anything political this year, since I don’t like doing it and was tired of having to do so for the last few years of the economic crisis. Second, the market has been shrugging this whole thing off as political theater. Interest rates have stayed low and the stock market is hanging in there, which tells me that investors don’t believe for a second that August 2 will pass without some sort of deal.
However, I have received a question that frankly surprised me. More than one client has asked whether I believe the debt ceiling should be raised. I then realized that through all this partisan noise of political negotiations and rumors that no one in our modern media has really taken the two seconds it takes to explain what this is all about. Ultimately the political debate is about two diametrically opposed visions of how a country should be governed: should we have a small limited government that does little more than protect personal property rights, or should we have a large and involved government that controls most every activity in our lives?
However, that isn’t fundamentally really about the debt ceiling. The debt ceiling just provides an excuse, some political leverage to have this ongoing debate which has been occurring here since the founding of our country and elsewhere in the world for much longer. That debate will not be settled by August 2; in fact, it never will be completely settled. The debt ceiling will be raised, however, and I can tell you why I am sure of that, and based on actual market activity, the market is sure, too.
The debt ceiling is a farce – we blew by it a long time ago. On or around August 2 when the philosophical posturing finally gives way to pragmatic reality, we simply will be admitting that we blew past it. The debt ceiling does not refer to actual debts or obligations the way real people and real companies have to account for their debt. If you and I were to create a personal balance sheet of our debts, or liabilities, we would not just include obvious things like our mortgage or car loans. We also would include bills received but not yet paid, credit card balances, and any promised future payments. When corporations prepare their financials they must list as liabilities their accounts payable and promised benefits such as pension or healthcare benefits that they have obligated themselves to pay some time in the future.
Government does not work that way. The debt ceiling refers solely to the amount of Treasury bonds the government can issue. If the government had to report its actual financial condition under the same accounting rules as corporate America, the $14 trillion ceiling would have been surpassed a long time ago. On August 2 we do not reach a date where our government can no longer make new commitments; we reach a date where our country can’t fulfill the commitments it has already made. That is unacceptable.
It is good that we have the debate on what our government should actually look like, and we need to continue that debate as we have throughout our history. However, the real time for that debate if before we make commitments, not when the bills come due.
This debt ceiling is a political mirage, an arbitrary rule which easily can be changed. The bond market is clearly signaling a willingness to buy more U.S. government debt, so we have not come close to a real ceiling. However, the lesson of Greece, Italy, Ireland, Portugal and Spain is that a ceiling is up there somewhere. On our current trajectory we will reach it some day. It may not happen for years, perhaps not even in my lifetime, but it will in my children’s. As a father that is not acceptable to me and I hope and pray it is not acceptable to you, either.
The political debate will continue and ultimately the ballot box will decide which view carries this day, but in the interim the government will raise the debt ceiling. There is no choice.
Chuck Osborne, CFA
~A Word on the Debt Ceiling