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.
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….
All this talk of quantitative easing reminded me I need to get my pants to the tailor for some ‘quantitative easing’ of my own in preparation for this Thursday’s feast. For those of you who may not have been paying attention to economic news over the past few weeks, the Federal Reserve has announced its…
Depending on your political views you are happy, sad, or indifferent about last night’s election results. Regardless of political orientation, most people probably believe that the election will be good for the stock market. After all, the stereotype is that Republicans are pro-business and Democrats are not. Certainly this administration and this past Congress have…
This summer has been about as hot as I can remember. When it is this hot, you want to do what a dog would naturally do – slow down, find some shade and take it easy. This reaction is about the only logical explanation for what is happening in the market right now. Sure, things…
Does it feel like déjà vu all over again? This market correction is going on longer than most – and we – expected. So what is the market telling us? The economic recovery is stalled. It appears at this moment that the surge we got in Q4 2009 was a rebuilding of inventories and now…
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
~2010: The Year in Review
All this talk of quantitative easing reminded me I need to get my pants to the tailor for some ‘quantitative easing’ of my own in preparation for this Thursday’s feast.
For those of you who may not have been paying attention to economic news over the past few weeks, the Federal Reserve has announced its intention to buy $600 billion in longer-term Treasury securities over the next few months in what is being called QE2. The very original name comes from the term quantitative easing, which is what the Fed is doing, and the number two, because this is the second time they have done this since the financial crisis and the ‘Great Recession’ first began. The idea is that the Fed will purchase longer-term securities in an effort to lower longer-term interest rates.
What is, in our opinion, more interesting than what the Fed has done has been the reaction. I cannot recall a time when the Fed has been attacked more than they have been for this announcement. Many of these attacks are based more on politics than economic reality. My personal favorite is the labeling of QE2 as “unprecedented.” (This is why I felt the need to explain where they came up with the number two in the name…see, they have done this before, which means there is a precedent, so it is not, in fact, unprecedented.) The other complaints have come primarily from foreign countries accusing the Fed of trying to devalue the dollar. Of course these arguments have come mainly from Germany and China, two countries whose economies are largely based on exports, and a weaker dollar makes German and Chinese goods more expensive here in the US.
In fairness there are legitimate criticisms, the most accurate of which, we believe, is that it simply will not work. It is more than interesting that the yield on the 10-year Treasury went up after the announcement of the QE2 program; however, by and large I think people are being unfair to Mr. Bernanke. The man has an impossible job. First, he must keep prices stable, and second, he must promote full employment. This is like the party host telling the bartender, “I want you to make sure everyone lets go and has a good time, but don’t let anyone get served too much.” This is the nature of the Fed’s “dual mandate” – under the current system it is the Fed’s job to do what they can to promote job growth, and with the Fed funds rate already at zero, quantitative easing is what they can do to promote job growth.
We believe QE2 won’t work because the lack of job growth has nothing to do with the lack of money. If anything, corporate America is sitting on too much cash. Companies are not spending because of the unusual level of uncertainty in our future, not for a lack of resources. But there is hope and reason to be thankful as we approach our national day of thanks. The proposals coming forth to help alleviate our budget woes are very encouraging. Of course there is always something not to like and pundits will get much more air time for singling those out, but the overall direction of lower tax rates with fewer deductions is a good thing. Just adopting one of the suggestions – lowering the corporate tax rate – will do more for unemployment than all the QE in the world. Who knows what, if anything, actually will come out of our new Congress in terms of deficit reduction and tax policy, but at least they appear to be starting from a reasonable point, and that is a big change from the past few years.
This continues to be a difficult time, but when we sit back and reflect on what really matters, the vast majority of us have much for which to be thankful this season. As is our tradition, here are some things for which I am grateful this year:
• Not being the Chairman of the Federal Reserve.
• A new Congress we can vote out again in two years.
• Positive equity market fundamentals.
• Not being Wake Forest’s new basketball coach (he may not want to unpack his bags).
• Having graduated from a university with an excellent academic reputation to which we can point when our athletic teams let us down.
• My many friends and family members.
• Mama’s pumpkin cheesecake.
• The quantitative easing of my waistband just in time for Mama’s pumpkin cheesecake.
• Being alive for another Thanksgiving.
I am also thankful for you, our clients and friends. Legendary hedge fund manager Seth Klarman was recently quoted as saying that the secret to success for an investment firm is to have good clients. I could not agree more. Thank you for your continued trust in Iron Capital.
Chuck Osborne, CFA
~‘Quantitative Easing’ and Other Thanksgiving Blessings
Depending on your political views you are happy, sad, or indifferent about last night’s election results. Regardless of political orientation, most people probably believe that the election will be good for the stock market. After all, the stereotype is that Republicans are pro-business and Democrats are not.
Certainly this administration and this past Congress have been anti-business to an extreme. Even MSNBC.com said this election was a “repudiation of the vast expansion of government.” However, I would caution against getting too excited about what is happening in Washington with regard to your investment portfolio.
Last night I did what I do with every election: sat on my sofa and flipped channels. This particular evening I watched the enthusiasm and pure joy on Fox News, and the wailing and gnashing of teeth on MSNBC. As is the norm, I saw the more measured responses of the three networks as well as the microcosm version of the same themes in local coverage. My wife told me the same story she always tells me, about how she took a college journalism class from Rodger Mudd, who suggested this is how one should always view the news – by comparing each outlet’s views. I responded as I do every two years, with the story of my father calling my mother to the television during the 1980 presidential election coverage to tell her that he thought Rodger Mudd was about to start crying.
Then I turned to CNBC and found the most personally entertaining of all the coverage. They had charts showing the possible effects the various election outcomes might have on the markets – if the Republicans control the House and the Democrats control the Senate and the Presidency, then the market does X; if the Republicans take both the Senate and the House, then the market does Y; if the Republicans control the House but only by this much, then that will happen; and if they control the House but don’t have a representative from Maine, then…or was it one of the Dakotas? I started to get very confused.
This morning we have already seen predictions ranging from the market being up 16% to the market being up 20% over the next six months. Lost in all of this noise about elections and politics is a simple truth of investing: a company that is still in operation is worth the present value of future cash flows. In other words, a company is worth whatever someone is willing to pay for its future earnings. Only two things really matter, what those future earnings are and what price you paid for them. That is it.
Everything else the talking heads fill our ears with – politics, price charts, economic indicators, even who ends up winning the Super Bowl – is at best secondary and at worst complete garbage. In the very long term, a company domiciled in a country governed by free market principles which places a high value on private property rights will tend to earn more than the very same company would in a country where the government over-regulates and nationalizes privately owned companies or gives them to a union and/or an Italian competitor based on political whims.
To the degree that a Republican House can stop these more extreme measures more effectively than moderate Democrats were able, our economy will improve and that will benefit corporate earnings and thereby the stock market. However, some of the best investment opportunities in the world have been in China, and they are still communist.
The market will be up, most likely substantially, several months from now, but it is not because of who just won the election. It is because, for the third quarter in a row, nearly 80% of S&P 500 companies have produced better-than-expected earnings, and the price for which we are currently able to buy those earnings is very reasonable. For those who were waiting for the election to get back in the market, you have lost out. Prices are still pretty good, but they were much better at the end of June. One of the keys to successful long-term investing is to recognize the difference between noise and information, and having the discipline to ignore the noise and act on the information.
This election has serious political ramifications, and is truly historic in that regard. Of course, the San Francisco Giants just won the World Series and that was historic too. If I could only find that chart about what the market does when the Giants win the Series right before Republicans take over the House…
Chuck Osborne, CFA
P. S. On a personal note, my apologies that it has been a while since we last sent out an “Insight.” That is mostly because there has been very little to report since we last told you to ignore August because the market was going to go up after Labor Day. It is also because we have a new addition to the Iron Capital family that has meant some sleepless nights for yours truly: Mary Frost Osborne arrived September 27, 2010. Everyone is happy and healthy and getting into the new routine.
~Change Is Coming to Washington. So, does that make it safer to go into stocks?
This summer has been about as hot as I can remember. When it is this hot, you want to do what a dog would naturally do – slow down, find some shade and take it easy. This reaction is about the only logical explanation for what is happening in the market right now.
Sure, things look bleak; pessimism is as high as it has been since March 2009. Unemployment remains high, growth is stagnant, Europe is falling apart, and the United States seems determined to follow. Everywhere you look there is bad news. But are things really as bad as they seem?
The macroeconomic news has been worse than expected and very well could be worse still, but corporate earnings have held up well. For the second quarter in a row almost 80% of S&P companies outperformed on bottom-line earnings, significantly more than normal. In the long run there are only two things that matter to stock investors, price and earnings. Earnings have gone up and prices have gone down, which has all the makings of a good buying opportunity.
As we had predicted, Q2 earnings came in better than expected and the market got a big boost in July. Then August came around and the market has drifted downwards in a jerky fashion. What is this market telling us? In our opinion it is telling us that it is hot out there and no one really feels like doing anything. August is a big vacation month and volumes are always slow, but this August is on pace to be the slowest since 1999. That is quite a feat.
With such slow volume you tend to get jerky trading and a slow decline in the market, which is exactly what has happened. There is no conviction however, and this leads us to believe you cannot read anything into August’s market action. The pros have taken August off, and until they come back to work we won’t really know where this market is going.
We remain cautiously optimistic. How can we say that in the light of so many poor economic reports? Our optimism is for the equity markets, not the broader economy. It is possible to have poor macroeconomic data and still have positive market results, and we think that is probable between now and year-end. First, as we have already stated, earnings continue to rise while prices have not. Second, corporations are sitting on huge piles of cash and they are starting to use it. Just this morning HP announced a large stock buy-back, and there has been a sharp uptick in mergers and acquisitions, which are good for stock prices even if they are not good for the economy as a whole or unemployment specifically. Finally, where else are the smart investors going to go? The 2.5% yield on 10-year treasuries won’t even cover the typical hedge fund’s management fee, let alone get them over the performance hurdle.
I know it is hot, but fall is right around the corner. So grab some lemonade, get a seat in the shade and remember things rarely turn out as bad (or as good) as they seem at the moment. Football will be starting soon, the pros will come back to work, the market will come back and before you know it we will be complaining about the cold weather.
Chuck Osborne, CFA
~Dog Days of Summer
Does it feel like déjà vu all over again? This market correction is going on longer than most – and we – expected. So what is the market telling us?
The economic recovery is stalled. It appears at this moment that the surge we got in Q4 2009 was a rebuilding of inventories and now that it is done, there is little to no carry-forward. That is what it looks like and that is what it feels like, but is that reality?
Geo-political news gets gloomier and gloomier. We are witnessing the collapse of the welfare state in Europe; China’s economy is over-heating and beginning to slow down; and of course there is all that oil in the Gulf. Unemployment has remained very high. Top this off with the sensationalistic nature of media coverage and it is no wonder we feel like we are headed to hell in a hand-basket.
I think it is time to stop, take a deep breath and ask ourselves: does any of this geo-political news actually impact the future profitability of the companies I own, and/or does it impact the credit worthiness of the fixed income investments I have made? We are not so sure that it does. It is hard to see a direct impact of Greece’s debt crisis on how many computers HP will sell, and I’m not sure that oil in the Gulf impacts Coca-Cola’s ability to pay its bond obligations.
Unemployment is a little tougher – it can and will impact corporate profits, as everything eventually traces back to the consumer. This is also a problem that is not going away, unless we get a complete reversal in policy direction. Americans have voted for a bigger more European-like government with more European-like social programs, and that comes at the price of more European-like growth and unemployment. Until this policy trend reverses we will not see American the unemployment numbers of 4% to which we had grown so accustomed. However, this seemed to be priced into the stock market already. Before this correction really got going stocks were at almost twenty-year lows in terms of price relative to expected future earnings.
The only way we will know for sure if all this bad news actually impacts the companies we own is to pay close attention to this earning season. If earnings are good, which is what we expect, we think we will see this correction end and the markets pop back up to positive territory. However, if the gloom is real, we could be in for another bear ride. At this point the market is still in typical correction territory, and we do not believe one can time in and out of normal corrections. However if the Bear raises its head, we will take steps to protect your portfolio. Watch earnings: that is the key.
Chuck Osborne, CFA