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.
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…
It has been a life-changing month for me and my family. For those of you who do not know, on May 15th I was hospitalized for treatment of a pulmonary embolism. I had multiple blood clots in both lungs, which the pulmonologist estimated were blocking 90% of the blood flow from my heart to my…
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
It has been a life-changing month for me and my family. For those of you who do not know, on May 15th I was hospitalized for treatment of a pulmonary embolism. I had multiple blood clots in both lungs, which the pulmonologist estimated were blocking 90% of the blood flow from my heart to my lungs. Every time a doctor sees my CT scans for the first time, they give me a look that tells me they are amazed that I am still here.
I am fine now and on the road to recovery, so why do I share this news? I share it because I think everyone should be as lucky as I am. When one realizes – really realizes – how truly fragile life is and that they could just as easily be gone from this world, it adds perspective to everything. In my opinion there is nothing we need more today than perspective.
My first winter in Atlanta (1992-93), we suffered through “The Storm of the Century.” The snow storm blanketed the entire east coast from New England to Georgia. My parents in Boca Raton, FL, did not get snow but did get powerful thunderstorms. It was a huge storm.
Of course news ratings spiked during the storm as everyone wanted to know what was happening. However, only the real weather enthusiasts knew that Gloria – a 1985 hurricane – had already been crowned “The Storm of the Century.” There was another winter storm in 1996 that tried to vie for the title but was not as successful.
I suppose it is human nature makes us want to believe that everything that happens to us, or on our watch, has to be bigger and more important than things that happened in the past. In sports, the greats of our time must be “the greatest of all time.” This is seemingly true with recessions as well; we can’t have just a severe recession, we must have the “Great Recession.” We can’t have just a devastating oil leak in the Gulf of Mexico; we must have “the worst environmental catastrophe in the history of humankind.”
I am no expert on environmental catastrophes and I certainly recognize the environmental and economic severity of the situation, but I do know that this is not “the worst oil spill in the history of humankind.” In fact it is not the worst oil spill in the Gulf of Mexico in the last 31 years. In 1979 there was a similar leak that went on for nine months before it was stopped. In 1991, approximately six times more oil was spilled into the Persian Gulf. Keeping this disaster in context and realizing that the world has seen even bigger catastrophes and survived, even to thrive again, would bring hope to the people on the Gulf coast. The blame game and “woe is me” syndrome doesn’t fix anything. However, calling this “the third worst water-based oil leak in the last 31 years” just doesn’t have the same ring to it.
While I am poking a little fun at the media and its hype machine, don’t think such dramatization of the situation doesn’t have consequences. Last week Reuters reported that Florida beaches were feeling the hit from a lack of tourism because of the leak. The headline was “Most beaches are clean, but misperception continues.” On Monday, mayors of two cities on Florida’s west coast were talking about the deep local economic impact even though there is no oil in sight.
The oil spill is not killing the Gulf Coast’s tourism industry, but our national lack of perspective and the media hyping the spill is. The media is no longer concerned with educating people about the events of the day; instead it is about ratings, and ratings come from good stories, not cold hard facts. Good stories have villains, so BP in this case becomes not a group of people that made a horrible mistake that cost the lives of eleven co-workers, caused horrible environmental damage, and damaged the future reputation and potentially the survival of the company, but a faceless inanimate villain that is deliberately trying to destroy the environment.
This makes for a great movie plot, but unfortunately this is not a movie. It is real, and in the real world corporations are not faceless inanimate objects, but organizations made up of real human beings – human beings who are flesh and blood, who have spouses and children, who volunteer to coach little league. BP is nothing more or less than the thousands of people that go to work there every day. A large number of those people, if not a majority, live in the Gulf Coast region. Does anyone really believe that they wanted this to happen or don’t care about the damage being done?
Yet, this is the story we get, and not just from irresponsible media outlets but from Facebook posts and other social media rants of college-educated friends. Worst of all, this is what we get from our elected officials. The Obama administration has promised to “keep a foot on the neck of BP” and have been looking for someone’s “ass to kick.” I think Jack Welch summed it up best in his CNBC interview Wednesday morning when he called the administration’s response “horrible” and added, “Here’s the difference between a businessman and a politician: Businessmen focus on solutions. Politicians focus on ‘who can we blame.’”
We have rewarded a sensationalistic media with our attention, and we have created a class of professional politicians rewarded by reelection – people who have no experience doing anything other than campaigning. They campaign to get elected, they campaign to pass their initiatives, and then they campaign to get re-elected. In a campaign it is you against your opponent, and you try to make yourself look good largely by tearing down your opponent. This is the only experience Obama has. From that perspective, what other response could we reasonably expect from him?
Unfortunately, in the real world, BP is not an opponent to be beaten. Yes, BP is responsible for this accident, but more importantly they are an essential partner in its solution. Destroying BP does not save the Gulf; in fact it makes it less likely that the Gulf will be cleaned up.
Instead of looking for an “ass to kick,” true leaders might be encouraging fellow Americans not to cancel their plans to visit the Gulf Coast this summer. True leaders might try to bring the oil industry together to help with the cleanup and to find ways to ensure this doesn’t happen again.
We should be so lucky. In the interim we will continue to focus on what our job is, managing investment portfolios. The good news about the sensationalistic media and irresponsible politicians is that they do create investment opportunities for those of us who still value reason. Perspective can change your way of thinking and help you see things in a different light. And a little perspective can be a very profitable thing.
Chuck Osborne, CFA