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.
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…
Has our society gone bipolar? As I understand it, people who suffer from manic depression, now called bipolar disorder, experience episodes of extreme mood swings from clinical depression to extreme elation. In the most serious cases it is all extremes, there is nothing in the middle. I think this describes our societal situation pretty well….
I’m not sure how it happened, but someone has caused a rally in the bond market. Commodity prices have been dropping, although not as fast as they should. Stock prices have been falling faster than they should, and bonds are rallying. The yield on the ten-year Treasury has dropped from 3.5 percent to just below…
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
Has our society gone bipolar? As I understand it, people who suffer from manic depression, now called bipolar disorder, experience episodes of extreme mood swings from clinical depression to extreme elation. In the most serious cases it is all extremes, there is nothing in the middle.
I think this describes our societal situation pretty well. It certainly seems true in politics; it even seems true in sports. Rory McIlroy makes history winning the U.S. Open with a record-low score, and immediately the golf pundits ask whether he will be the next Tiger or a flash-in-the-pan flop. Evidently those are the only choices. Why can’t we just enjoy the moment for what it is?
Of course it is most true in the financial markets. It starts with economic forecasts. In my twenty years in this profession I have never seen forecasts change so often and so dramatically. Release two good pieces of data and suddenly the recovery is right around the corner and the market is up – the S&P rose over 6.68 percent in the last eight business days of June. One bad report and we are headed for a double-dip; we have lost over two percent already in July. What has actually occurred is that our economy is sluggishly growing at around two percent. This is what two percent growth looks like: mixed economic reports with the only constant being no real jobs growth.
What is really maddening about this market bipolar disorder is that, just like the real disorder, reason has gone out the window. Let’s look at the last two days: the big economic story on the Sunday news shows was the debt ceiling debate in Washington. Our Treasury secretary was making the rounds, letting everyone know that the U.S. will default on its debt on August 2 if a deal is not reached. Many believe this itself is an exaggeration, but for the sake of argument let’s take Mr. Geithner at his word. How should the market react if the U.S. is going to default on its debt?
I would assume that there would be a massive sell-off in Treasuries and interest rates would go through the roof. I would assume a short-term panic in the stock market because that is what people do, but no real long-term impact, since people would continue to drink Coca-Cola, shop at Wal-Mart, and get on the iPad to keep track of the government meltdown, and ultimately realize investing in some of these companies makes sense. This is because I seem to be suffering from this attack of reality: I still believe that Treasuries are the debt obligation of the U.S. Government – the guys who are going to default on August 2 – and that stock represents partial ownership in privately run corporations, who are not going into default on August 2.
So what did happen Monday? Stocks were down around two percent and Treasuries were up. That is correct, they were up.
This may because our friends on the other side of the pond are actually headed for default, while no one seems to believe Mr. Geithner. Therefore, threats aside, the investing world still trusts U.S. Treasuries, at least more than they trust European debt. However, that leads us to yesterday. The big fear now is that Italy is going to follow Greece into default. It makes sense for anyone who studied Western Civilization. The Roman Empire followed the Greek Empire; certainly they would follow each other in the never-ending debt crisis. The world markets were down dramatically because of the fear of Italy’s default. Then, Italy announced that they had a “successful” auction of one-year notes. The interest rate at which they finally sold was 3.67 percent, up from 2.147 percent in June, and they barely got them all sold. This “good” news sent the Italian market, which was down 4.8 percent at the time, on a tear. Their market closed up 1.17 percent – an almost six percent jump because interest rates had only gone up 1.5 percent in a matter of three weeks? Bipolar is the only explanation.
The primary symptom in the market bipolar syndrome is that there is only one trade to make. It is the “risk-on, risk-off” trade. When the bad news comes we pile into Treasuries, even if the bad news is that Treasuries are going to default. When the good news comes we pile into the same stocks that have been doing well over the past year – small caps, energy and materials – even if the P/E on small caps is 30 and the commodity bubble shows signs of collapsing. One of the things I love about my job is that every time I think I have finally seen it all, they come up with some brand new kind of insanity.
The silver lining in all of this is that volatility does bring about opportunities for those of us who are investing for time horizons measured in years and not minutes. The S&P 500 is selling at 13 times forward earnings, and certain sectors, such as large-cap technology, look very attractive. There may be some short-term pain, but when companies like Cisco are selling at 8.67 times earnings when adjusted for their net cash position, it is hard to see how you won’t make money in the next year or two.
Reality is usually in the middle. Unless there is a dramatic change of course from the policies of the last decade, our economy will continue to grow at a very European rate of two percent, not at normal U.S. growth standards, but not a depression either. Rory McIlroy will most probably be a solid Hall of Fame golfer, but neither another Tiger Woods nor a flash in the pan. Most importantly for us, Treasuries will most likely deliver the three percent return their yield indicates, and stocks will likely grow at the approximately ten percent their earnings yield is indicating. We will see neither a boom nor a collapse in the long run.
In the meantime, the market never ceases to entertain. I love my job.
Chuck Osborne, CFA
~Manic-Depressive/Bipolar Disorder: Do We All Have It?
I’m not sure how it happened, but someone has caused a rally in the bond market. Commodity prices have been dropping, although not as fast as they should. Stock prices have been falling faster than they should, and bonds are rallying.
The yield on the ten-year Treasury has dropped from 3.5 percent to just below three percent. For those who need a refresher, bond prices move in the opposite direction of interest rates, so a drop in the yield equals an increase in the price. To understand the oddity here one must put all of this in context.
The Federal Reserve has been buying up Treasuries in a program commonly referred to as QE2. Some have estimated that the Fed’s purchases represent as much as 30 percent of current demand for Treasuries. This program is about to end. Economically if the largest purchaser of Treasuries stops buying, the price should go down, not up.
Down the street from the Fed our representatives in Congress are debating whether to raise the debt ceiling. Treasury Secretary Tim Geithner has told us that if this does not occur then all these Treasuries will be in default and the world will actually come to an end on August 2, not October 21 as that other guy predicts.
Moody’s is threatening a downgrade of Treasuries. Bill Gross, the man who manages more bond assets than anyone else in the world, has very publically taken a short position in Treasuries. Yet, the Treasury market rallies?
I can understand the market ignoring Geithner’s warning of sudden doom on August 2. I don’t believe anyone seriously believes that Congress will not raise the debt ceiling. In the interim we are witness to a lot of political theater and some smaller amount of actual negotiation between the Administration and Congress. However, does anyone not think QE2 is going to end? Does no one care that the world’s preeminent bond man is going short and one of the largest rating agencies is considering a downgrade?
The bond market’s answer? “No.” It doesn’t care. How can this be? We have been pondering this question for weeks now, and have come up with only one somewhat satisfactory answer: old habits die hard.
Shortly after the earth cooled and mankind started walking on it, that talking baby in the E-Trade commercials and his trading friends invented the ‘risk-on risk-off trade.’ We see it everywhere. The simple version is evidenced in almost every individual portfolio I have ever seen (before it comes to Iron Capital, that is), made up of nothing but equities and cash. The self-proclaimed “savvy” investor usually talks about going into and out of “the market” – a statement which is evidence enough of a lack of actual savviness. The professional version of the same disease is the rotation between Treasuries and anything else that isn’t a Treasury.
In other words, the only explanation we can come up with for the piling into Treasuries is that, with all their current faults, Treasuries are still the safe haven for temporarily parking money when you don’t know what else to do.
The unfortunate part in this knee-jerk reaction is that safety in investing is not, as some believe, a permanent design feature. The ‘stocks are risky and Treasuries are safe’ mentality is naïve to say the least. Let’s not forget that it was the mortgage-backed securities with their quasi-government backing making them “almost as safe as Treasuries,” which caused the market meltdown of 2008. Safety is not a function of product design; it is a function of price compared to actual value. In that light, Treasuries are not looking so safe today.
There are those who disagree with this position and will claim that the risk to principal is overstated. I believe they are missing the point. We often repeat the quotation from Benjamin Graham that a sound investment offers safety of principal and an adequate return. As I write, the 10-year Treasury offers a return of 3.125 percent. Even if we are wrong about the risk to principal, I don’t know many who would call that an adequate return. Graham says the purchase of securities which fail his test – any part of his test – is not investing but speculation, and that is exactly what the risk-on risk-off traders are doing.
Chuck Osborne, CFA
~Old Habits Die Hard