The difficulty lies not so much in developing new ideas as in escaping from old ones.
John Maynard Keynes
Our insights, reflections and musings on the most timely topics relevant to managing your investments.
On Friday Goldman Sachs Group Inc. was hit with charges of fraud by the SEC. That is a big headline, and it is worrisome; are major financial firms really committing fraud as a regular order of business? Goldman denies any wrong-doing and says it will fight the SEC allegations. Right now we are left with…
US stock markets have recently rallied to new 18-month highs as economic reports suggest improving conditions. The long-term outlook remains encouraging for the economy and the stock market, but prospects for another short-term pullback or correction like the one we saw in late January have increased. First, the factors suggesting economic improvement: The statement from…
Today’s Insight comes from Todd Smallwood, Iron Capital’s new director of trading. More information below on Todd’s vast experience. Many investors have been concerned by the drop in the US stock markets from the January highs and are asking if we are in a correction or worse, the beginning of a bear market. Let’s break…
Have you ever noticed how your expectations going into an event can have a dramatic impact on your enjoyment of that event? For example, several years ago I almost left the theater during Lost in Translation, an incredibly depressing movie in which one of the funniest men on the planet, Bill Murray, shows his serious…
It seems everywhere I look this week I see stories about how bad the last decade was. Of course the two recurring themes are terrorism and the economy, since the decade began with the bursting of the technology bubble and the day no one will ever forget – September 11. Time is a funny thing….
On Friday Goldman Sachs Group Inc. was hit with charges of fraud by the SEC. That is a big headline, and it is worrisome; are major financial firms really committing fraud as a regular order of business? Goldman denies any wrong-doing and says it will fight the SEC allegations. Right now we are left with more questions than answers, including the seemingly political timing of the announcement, so for the moment I will withhold judgment on Goldman’s actions. However, I think this case is all too illustrative of how Wall Street works to allow it pass without comment.
Let’s quickly review the facts of the case as they have been reported thus far. The hedge fund firm of Paulson & Co. asked Goldman Sachs to create a Collateralized Debt Obligation (CDO) security, which included particular mortgage securities that Paulson was interested in shorting. To put this in layman’s terms, Paulson wanted Goldman Sachs’ help in betting on the value of mortgages going down. Goldman Sachs created the security and sold it to clients while Paulson bet on it losing value.
Pay close attention here. If you do not remember anything else about this scandal, remember this: these facts are not in dispute, and the SEC did not say there is anything wrong with what Goldman did. Their argument – the entire case – is simply that Goldman did not disclose material facts. Paulson has not been charged with any wrong-doing. There would be no charges at all if the SEC felt that Goldman had the appropriate disclosures in the contracts their clients purchased. The big picture facts in this case do not represent fraud; they represent the Wall Street business model.
Wall Street firms are brokers, not advisors, regardless of what they call themselves. Their job is to bring buyers and sellers together. As the legendary money manager Michael Price once said, “Wall Street is in the business of creating fees for Wall Street. Period. It is not in the business of getting good investment results. You have to be separate from Wall Street to do that.”
Goldman’s CEO summarized it best last month in a letter to shareholders when he said, “Our goal was, and is, to be in a position to make markets for our clients while managing our risk within prescribed limits.” Their goal is to “make markets” – to bring buyers and sellers together – not to provide advice and get a competitive rate of return for their clients.
I don’t know whether Goldman committed fraud. I am willing to allow our legal system to find that out. I do know that Goldman, and every other Wall Street firm, believes their role is to make markets, not to provide advice.
Regardless of the outcome, if one has a retail account at Goldman, JP Morgan, Merrill Lynch, Morgan Stanley, UBS, Wells Fargo Securities, or any other full-service broker dealer, that person should understand that they are on their own. Every time their broker, a.k.a. “adviser,” calls them with a suggested investment, they need to know that the opportunity has arisen because some other client of the firm is selling that very same investment, not because the investment is in the client’s best interest.
Fortunately, Iron Capital provides an alternative. Our goal is not to create markets but to provide counsel and to generate superior rates of return on our clients’ investments. If we buy an investment in your account, we are buying it for ourselves as well, and if we sell an investment out of your account, we are selling too. If you have ever wondered what the real difference is between Iron Capital and a firm like Goldman Sachs, you found out on Friday.
Iron Capital owns Goldman Sachs in several client accounts. We do business with Goldman and will most likely continue to do so. Regardless of what you may think of them, they do a very good job of their stated goal – creating markets – and as professional investors, we need markets. The problem in our system is that somewhere along the way people forgot what business the Wall Street firms are really in. Their role is to work with firms like Iron Capital and Paulson & Co. and to provide us with markets for the securities in which we wish to invest. It is our role to provide you, our clients, with independent investment counsel.
Chuck Osborne, CFA
~Wall Street Revealed
US stock markets have recently rallied to new 18-month highs as economic reports suggest improving conditions. The long-term outlook remains encouraging for the economy and the stock market, but prospects for another short-term pullback or correction like the one we saw in late January have increased.
First, the factors suggesting economic improvement: The statement from the Federal Reserve following the March 16, 2010, meeting noted that “economic activity has continued to strengthen and the labor market is stabilizing. Household spending is expanding at a moderate rate but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. While bank lending continues to contract, financial market conditions remain supportive of economic growth.” Inflation remains benign as indicated by the recent release of the Consumer Price Index (2.2%/year), industrial production rose for the 8th straight month, and factories are operating at the highest rate in a year (72.7%). Also positive, the Philadelphia Fed Survey revealed significant gains in the six-month business outlook that showed a rise in expectations for new orders, and suggested a majority of manufacturers expect to increase production in the second quarter.
Now let’s review the indicators for a short-term pullback: The S&P 500 had dropped 9.2% from 1,150.45 on January 19, 2010, to an intraday low of 1,044.50 on February 5th. This came very close to the target 10% drop to 1035.40 we suggested in our last Insight (“Correction or Bear Market,” February 4, 2010). With the added luck of the Irish, the index subsequently rallied 12% to 1,169.84 by St. Patrick’s Day (March 17), the highest since September 2008. This was up 75% from the March 2009 intraday low of 666.79. On the same day, the Russell 2000 index was up just over 100% (342.59 to 686.94) from its March 2009 low. Prior doubles in the Russell 2000 have triggered corrections in the past. John Schlitz from Instinet recently identified the following examples: “October 1987 to February 1992 (+101%, followed by a -14% correction), October 1990 to February 1993 (+96% / -8%), July 1992 to May 1996 (+97% / -17%), December 1994 to October 1997 (+99% / -13%), October 1998 to March 2000 (+102% / -28%), October 2002 to December 2004 (+102% / -14%) and March 2009 to March 2010 (+100% / ?). While those events suggest a choppy fire-fight isn’t too far off, keep in mind that only the 1998 to 2000 double resulted in lower prices six to twelve months later.”
Reviewing additional technical indicators reveals overbought conditions where prices are considered too high and susceptible to a decline. This should not be confused with being bearish; it merely suggests that perhaps we have risen too far too fast and might be due for a pullback.
When the stock market appears vulnerable, at Iron Capital we are vigilant in looking beyond technical indicators for potential catalysts that might confirm the view of a short-term move lower. Of particular concern are the uncertainties surrounding the sweeping overhaul of the nation’s health care system, financial regulatory reform, and huge government deficits both here and abroad. Winners and losers in health care may appear obvious (insurers have 32 million new customers), but a closer look reveals a more complicated picture (significant risk of an altered business model peaking in 2014). Costs and benefits for businesses from health care and regulatory reform remain difficult to quantify. Leaving little room for error, these historic changes are occurring while the U.S. is using about 7% of tax dollars to pay debt this year, and almost 11% by 2013.
The point of identifying these risks is so we can position ourselves defensively when needed, while preparing to pounce on undervalued stocks when given the opportunity. Economic momentum appears positive, which should translate to better earnings and higher stock prices, at least before elections this fall.
Director of Trading, Iron Capital Advisors
~The Outlook Remains Encouraging
Today’s Insight comes from Todd Smallwood, Iron Capital’s new director of trading. More information below on Todd’s vast experience.
Many investors have been concerned by the drop in the US stock markets from the January highs and are asking if we are in a correction or worse, the beginning of a bear market. Let’s break it down.
According to Vanguard, “While there’s no agreed-upon definition of a bear market, one generally accepted measure is a price decline of 20% or more over at least a two-month period.”* A bull market could be defined as a long period of time when prices are generally increasing. A correction is commonly defined as a price decline of at least 10%, occurring within a longer-term bull market.
To determine where we might be headed from a technical analysis perspective – a study of market action, usually with price charts – it helps to look at where we came from. The bear market in the S&P 500 index started in October 2007, when it began a 57.4% decline from the high (1,564.74) to the March 2009 low (666.79). What followed was an astonishing bull market rally from the March intraday low to the January 19, 2010, intraday high (1,150.45) of 72.5%. The index then dropped 6.9% over the next eight business days to a low of 1071.59 on January 29. Why did we drop? Where does the market go from here?
Rarely have we seen a rally of this magnitude without a correction, yet we have not had a drop of at least 10% since March 2009. As a bull market’s gains continue, short-term investors or speculators typically look for an opportunity to lock in their gains by selling their biggest winners, thus triggering price declines that can lead to a correction. Long-term investors typically remain fully invested through a correction, and avoid trying to time the market to realize long-term gains. A correction is thought to be a healthy event for a bull market because it gets many of the speculators out of the stocks with the biggest gains, creating opportunities for long-term investors like us.
In percentage terms the rally appears overdue for a correction, and several catalysts appeared in late January that may have started the process. First, China announced steps to slow growth (GDP +10.5%) by increasing the Bank Required Reserve Ratio and instructing banks to curtail lending. Additionally, European growth appears shaky as the sovereign debt of Portugal, Ireland, Greece and Spain are under selling pressure due to large deficits and downgrades. As bond prices drop, interest costs rise, leading to reduced funds for government spending. This leads to the fear of slowing global growth, which in turn led to a drop in commodity prices, particularly copper and oil, which both dropped around 13% from the January highs. Finally, the U.S. Administration’s proposals for bank regulations have led to a sell-off domestically, with Bank of America, JP Morgan, and Citigroup all dropping more than 13%, and technology stocks in the S&P 500 have dropped an average 10.6%.
Techs, financials, and commodities have been leading the market higher from the March lows, and now they are signaling that the market may be headed toward a correction.
For the S&P 500 to achieve a 10% drop defining a correction, the index will need to fall below 1,035.40. We would see this as a healthy sign. We are not concerned about short-term corrections that flush out speculators and allow the longer-term bull market to keep moving forward; we are concerned, however, about protecting against a true bear market. At this point we do not see a bear on the horizon, with approximately 80% of S&P 500 companies outperforming on quarterly earnings, but we remain ever watchful.
Director of Trading, Iron Capital Advisors
~Correction or Bear Market?
Have you ever noticed how your expectations going into an event can have a dramatic impact on your enjoyment of that event?
For example, several years ago I almost left the theater during Lost in Translation, an incredibly depressing movie in which one of the funniest men on the planet, Bill Murray, shows his serious side. The movie couldn’t have been as bad as I remember because it won lots of awards, and lots of people I know said it was great…but I really think that is the problem: I went into the theater expecting a great movie, and I was disappointed.
Conversely, I remember the first time I went to Poland for work. My employer at the time had purchased a pension operation there and the portfolio was underperforming badly. I was told to “go fix it.” I am ashamed to admit I had very low expectations going to Poland for the first time – I was dreading spending three weeks in a dark, cold, depressing place with sad people and bad food. Yet everything about Poland came as a pleasant surprise to me. Don’t get me wrong – if you have never been to Europe and you have the opportunity to go to either Warsaw or Paris, go to Paris. The point is that low expectations can be a beautiful thing.
Expectations are the issue in the market right now. For nearly a year we have been climbing out of a hole based on performance that has been not that great, but has been much better than expected. Economists were talking about a “new normal” of slow growth and high unemployment here to stay. While there are still several in that camp, more and more economists are becoming born-again optimists. GDP growth in 2010 is now expected to be about 3%, and corporate earnings are expected to be up 25%. Those are the official expectations. More and more market watchers are expecting firms to beat expectations, which simply means real expectations are higher than the experts are willing to put in writing.
Why the sudden shift to the positive? First, we are Americans. We are an optimistic bunch. This crisis has been a big blow, but eventually our true nature will triumph. Secondly, it is becoming increasingly apparent that we may dodge the worst of the anti-growth policies now that the political winds have shifted dramatically. It is always dangerous to bring up politics, I know, but let me make this clear: it was Pimco’s CEO, Dr. Mohamed El-Erian, who coined the phrase “new normal.” He was, and I would assume still is, a very public supporter of the current administration. However, not being a politician, he understands that there is an economic cost to a European-style social safety net. The policies which Dr. El-Erian supports are a big part of his “new normal” theory, and he is completely honest about such.
The danger now lies in an overly optimistic view. Intel posted record profits, had a rosy outlook, and the stock still traded down 2% on the day they reported. Nucor blew earnings estimates away just this morning and still opened down. It is becoming increasingly possible that we could see good economic growth and still have stock prices go nowhere because expectations were too high. Remember, the market does not move based on economic news; it moves based on surprises.
We must remember the lesson that Benjamin Graham passed down to his star student, Warren Buffett: Be greedy when others are fearful and fearful when others are greedy. I’m not sure I would go so far as to say these rose-colored outlooks are greedy, but they are certainly less than fearful, which leads us to be cautious.
Chuck Osborne, CFA
Managing Director, Iron Capital Advisors
It seems everywhere I look this week I see stories about how bad the last decade was. Of course the two recurring themes are terrorism and the economy, since the decade began with the bursting of the technology bubble and the day no one will ever forget – September 11.
Time is a funny thing. In one sense it seems like a lifetime ago that we were worried about Y2K, yet it seems like just yesterday I was fighting for IT resources to build a new and improved research database at Invesco. (Side note: I really don’t miss working at a big firm.) It also seems like yesterday when I was standing in the Invesco executive conference room watching, in shock, as the Twin Towers burned, while my boss, standing next to me, kept muttering under his breath, “I was just there last week.” He had been at Aon Consulting. Their offices were on the 102nd floor of the South Tower, and they lost nearly everyone.
It seems that everyone I know has a story about the tech bubble and/or 9/11. They really did define the decade, and when you look at it from that perspective it is no wonder almost every story has been about how bad the first decade of this century has been. Then, as proof of how bad the decade was, we get the worst 10-year return in stock market history (which is not actually true if you look at all 10-year periods. but is true for calendar decades).
This evidence gets used as proof that stocks won’t do well going forward, but here is a thought as we head into this new decade: there are few powers in the universe stronger than what statisticians refer to as ‘regression toward the mean.’ I can’t explain how or why, but the stock market provides an average 10% rate of return – the mean. Even after the worst calendar decade in history, the S&P 500 over the last 30 years has provided a 10.4% annualized rate of return. I once worked with a gentleman named Ivory Day who studied 30-year rolling periods of time going back as far as he could find the data. He noticed that over these long time horizons, the returns on stocks were very stable and always right around the 10% mark.
I never fully bought into Ivory’s analysis. I am in the camp that believes there must be more to the future than history simply repeating itself. There must be some reason stocks go up 10% per year on average. But here we stand and sure enough, after this most painful decade, all we did is go from the highs of the biggest 20-year run in stocks to once again revert to the mean.
We face some tough economic times ahead. Debts eventually will have to be paid, and higher taxes will slow growth. However, if Ivory’s wisdom is correct, we will be entering a pretty good decade for stocks. In fact if he is right, by my calculations we will have to average around 14% per year for the next ten years for that 30-year period to get back to the 10% mean.
Sounds a little too optimistic, but it is the beginning of a new decade and we could all use some optimism. Ivory, if you are reading this – I’m pulling for you and your theory!
Happy New Year!
Chuck Osborne, CFA
Managing Director, Iron Capital Advisors
~A New Decade