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Iron Capital Insights

  • Iron Capital Insights
  • October 24, 2014
  • Chuck Osborne

The New Math, Same as The Old

“The difficulty lies not so much in developing new ideas as in escaping from old ones.”
~ John Maynard Keynes

Our instincts on the market downturn seem to be correct. We touched the magic ten percent correction threshold and the market has been rallying since. Predicting the future is impossible of course, but the odds favor a continued rally from this point. There are two questions which we received during the course of this downturn that deserve to be addressed.

The first is, “If you knew the market was going to go down ten percent, why not get out the then back in?” The second related question is, “How are you so sure this isn’t something more serious than a correction?” The answer to the first question is that if we could time that type of thing perfectly we would, but we can’t, and no one else can either. Timing market corrections is a fool’s errand. It is always tempting and it always seems like it would have been so easy in hindsight. That is because in hindsight we see only what did happen and we tend to believe, incorrectly, that what did happen was the only possible outcome.

In reality lots of things could have happened. It is never exactly clear in real time when corrections have begun or when they are over; that becomes clear only after the fact. The market could have bounced back after dropping four or five percent, as happened several times since the last correction. The market could have gone down twelve or fifteen percent; the ten percent rule of thumb only holds true because it is a self -fulfilling prophecy. The text books say ten percent, so people expect ten percent, so the traders come back in at ten percent. It is self-fulfilling, and usually holds, but the few times it doesn’t tend to be bad, so jumping back in just because the market hit the magic ten percent rule is risky. The best thing to do during corrections and in their immediate aftermath is ride them out and look for opportunities to potentially rebalance.

The second question has to do with our fundamental belief in investing from the ground-up, one security at a time. For prudent investors investing is all about the price one pays for the future cash flow one is likely to receive. In the stock market that means the earnings of the companies whose stock one owns. For a bear market to occur there must be a disconnect between stock prices and actual company earnings. In 2000 it was the prices that had gotten crazy. That was a fairly easy thing to predict, although most who predicted it did so two or three years before the actual bursting of the bubble.

In 2008 the prices seemed fine; it was the earnings that disappeared. Those markets are harder to predict. We predicted it in January of that year when unemployment began its rise. The poor market had actually begun in the fall of 2007, but it got worse because the real economy was deteriorating.

This time prices are once again okay, so for the market to really tank, earnings would have to take a big hit. For that to happen the economy must shrink, and that is not happening. Having said that, one of the catalysts for this latest downturn was the International Monetary Fund (IMF) revising their economic outlook downward. That sounds, bad doesn’t it? Until one realizes that the IMF has had to lower their economic outlook 100 percent of the time since 2011 – the approximate end of the European Debt Crisis.

What has happened over the last few years is that the economy itself has been extremely stable. It has been sluggish for sure, but the slow crawl has been very steady. During this same period, however, the forecasts have continued to swing wildly. Central bankers, the IMF, and economists in general have not adjusted to the reality of this slow economy. This is largely due to their unswerving belief in the power of government to steer an economy through fiscal and monetary policy.

Many of those believers call themselves Keynesians, after John Maynard Keynes who was the source of many of their beliefs. Keynes himself had a very nimble mind. In his career as both an economist and a money manager he allowed new information to change his mind. I have often wondered, if Keynes were alive today would he be a Keynesian? I rather doubt it. The man who once said, “The difficulty lies not so much in developing new ideas as in escaping from old ones,” must be laughing in his grave at the idea that his ideas are now the old ones.

Regardless, nothing of substance has changed in our economic reality from the beginning of October until now. Prices are reasonable, the economy is not tanking, and investors are still well-served staying invested.

Chuck Osborne, CFA
Managing Director