Iron Capital Insights

  • Iron Capital Insights
  • October 24, 2011
  • Chuck Osborne

See No Evil, Hear No Evil, Speak No Evil

What happened to the European debt crisis that caused so much market turmoil in August and September? What happened to the slow U.S. economy and mountain of government debt that caused the U.S. credit rating to be downgraded by Standard and Poor’s?

To my knowledge nothing has happened to fix these situations, but don’t tell that to the stock market. Stocks have gone on a tear in the month of October and seem to be shrugging off all the worries that had caused them to go down so far in September. This seems to be the manic phase of the manic depression we have been in for more than a year now. In the interim, all hopes seem to be resting on what the European leaders do on Wednesday.

For those who need some catching up, European leaders have issued a self-imposed deadline of Wednesday to bring forth a plan to finally bring their debt crisis to an end. Of course they already did that three months ago, or so we were told. This brings us to a large disconnect: the European bond market is pricing in failure as the spread has widened considerably between the “safe” German Bund and the rest of Europe – including countries like France, not just Greece and the other so-called PIIGS. This tells us the bond investors think there is a likelihood of a Europe-wide recession.

The stock market, especially our stock market, seems to be ignoring such inconvenient news. Of course there have been some positive earnings announcements, but we have had those all along. There have been some merger and acquisition announcements, but that is not out of the ordinary. I think most of this rally is based on the hope that Europe actually will have a real plan come Wednesday. Certainly that is possible; it could happen, and if it does, that would dramatically change the outlook on our economy and the stock market over the short run.

But how likely is it? The bond investors in Europe are telling us it is not likely at all, which brings me to a realization I made about 15 years ago. That was the first time I sat down with some former PIMCO analysts who were starting their own firm. I was blown away; these were the smartest people I had ever met in my life. This is a bold statement, since I have been blessed with fantastic educational experiences and have been surrounded by very smart people all my life. These guys were, to be flip, wicked smart.

When we left that meeting my colleague and I were both impressed. My colleague was a former college professor with a PhD – he himself was no idiot. I told him I thought these were the smartest guys I had ever met, and he responded, “You have to be smart to manage a bond portfolio. Any idiot can pick stocks, but the bond guys are smart.” No truer words have ever been spoken.

Perhaps the stock market is correct and come Wednesday the worst financial crisis since the Great Depression will just be over, Europe and the rest of the world will go on to prosper, and stock prices will climb to the sky. Or, perhaps come Wednesday, or some time thereafter, we will be reminded that this crisis in Europe is far from over and that the risk of global recession is very high.

The wicked smart guys are betting on the latter. They could be wrong, it is possible. The stock market seemingly sees no evil on the horizon, hears no evil on the horizon and speaks no evil on the horizon. It would be great if the stock market were correct, but until the smart guys agree I think it is prudent to remain defensive.

Chuck Osborne, CFA
Managing Director