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The Quarterly Report

  • The Quarterly Report
  • First Quarter 2009
  • Chuck Osborne

Anger Management

The great philosopher and leader of the Jedi Knights, Yoda, nailed it. Last year was defined by fear – fear in the mortgage market that led to fear in the bond market that led to fear in the stock market that led to fear in the real economy. Fear defined us in 2008, and just like the wise master counseled a long time ago in a galaxy far far away, fear has led to anger.

We are mad and we aren’t going to take it anymore. In many respects this anger is justified. It is righteous anger at the audacity of those who got us into this mess. However, there are two major issues with this anger. First, anger does lead to hate, which does lead to suffering, and most of the time that suffering is done by those who are angry, not by those on whom the anger is focused. Anger eats one up inside and leads to irrational decisions that are not necessarily in anyone’s best interest.

Secondly, and perhaps more importantly in this case, much of the anger is mistakenly aimed at “the rich” as an entire class, and at capitalism itself. The anger was intensified by bonuses paid to employees of firms such as AIG and Merrill Lynch, and most recently Freddie Mac and Fannie Mae. People certainly have a right to be mad. These were the very organizations that led us down this destructive path. But the anger is not stopping there. People are angry that some people get large bonuses period, and they are blaming it all on capitalism.

What they don’t understand, and to a certain extent what the people who got us into this mess didn’t understand, is that Wall Street is not capitalism, and the free market is not the stock market. Living in a free-market capitalist society on a daily basis has more to do with the grocery market than the stock market.

Free-market capitalism is about your right to shop where you want to shop or work where you want to work. If you want to start your own business, you can, since you are free. Companies are free to compete and consumers are free to choose.

Wall Street, or more correctly the capital market, is not the “system;” rather, it is a helper to the system. We seem to have lost track of that reality. Twenty years ago, Wall Street consisted of mostly independent firms who were focused on raising capital for successful businesses or managing investments. Internally we referred to the two sides of Wall Street as the “sell side” and the “buy side.” The sell side was made up of investment banks and broker-dealers that focused on helping companies grow by providing access to capital through the stock and bond markets. The buy side was made up of investment advisory firms that helped institutions, such as pension funds, and individuals buy stocks and bonds for investment purposes. The two sides were completely separate and combined represented less than 18% of the total corporate profits of the US. Most of these firms were partnerships, not publicly traded companies, and the risks they took were borne directly by the partners and clients.

Today, these lines have been blurred. Most Wall Street firms are publicly traded companies whose risks are borne by the shareholders and clients, not by management. They have grown to represent 41% of the US corporate profits as of the end of 2007. They are in all sides of the business even though this represents huge conflicts of interest. They are no longer interested in helping companies or in helping investors. Their only interest is in manufacturing products that are profitable to them.

One amazing aspect of the financial services industry is that they were seemingly able to create their own demand for any product they wished to push. At the beginning of this decade, I was still at Invesco. AIM, Invesco’s mutual fund division, was introducing separately managed accounts. These were mutual funds without the funds. Clients would get their own accounts with all the underlying securities that were in the mutual fund, for over double the price of the mutual fund. I asked why we were doing this, because it seemed insane to me that anyone would pay more than double for what is essentially the same thing. I was told that there was “huge client demand.”

I have never been one to simply believe what I am told, so I did some investigating and began asking people who had invested in these products why they did it. Every single time, I was told that they did it because that is what their broker recommended. I even had some people ask me, “Why is my broker ’pushing‘ these accounts?” Granted my investigation falls short of a true scientific survey, but I will bet the farm that there was zero true client demand for so-called separately managed accounts. The demand was created by the Wall Street firms themselves.

Why the firms wanted these instruments is obvious – they get the lion’s share of the fees, and more importantly, 100% of the trades. Clients don’t balk because these trades are “commission-free.” What clients don’t understand is that commissions are just the beginning of trading costs that go to the Wall Street firm. The only reason someone would invest in these products is to make more money for the Wall Street firm.

The firm tells their brokers to push this product, and they do what they’re told. Clients believe their brokers are “advisers” with only their best interest at heart, so they agree. How do these people sleep at night? They are protected by layers. The money managers never meet the clients. Many firms have even created a position called “client portfolio manager” who poses as the money manager if larger clients insist on meeting someone, but they are not actually the manager. Most money managers don’t care to meet the client and rarely give the client a thought, because they are doing what they love, getting paid well for it, and dealing with the client’s best interest is someone else’s responsibility. That responsibility falls on the shoulders of the broker, but the brokers aren’t investment professionals and don’t know anything about investing that they have not been told by their bosses, who are telling them to push this product.

Nowhere has this pattern been clearer than in the explosion of “alternative investments.” The argument goes that an investor should diversify away from stocks and bonds. They should invest in commodities, emerging market stocks, and – always included in the list – hedge funds. We are told that hedge funds are very risky, so we should not invest in just one hedge fund, but in a fund that invests in other funds. So the investor goes to an adviser who recommends a hedge fund “fund of funds” because that is the latest craze. The manager of the fund of funds gets paid a fee, the actual hedge fund managers get paid a fee, and the broker gets paid a fee. The only person who doesn’t make out in this deal is the investor, whose profits are eroded by everyone else’s fees.

The defenders of these strategies will say they are emulating the huge success of college endowment managers at places like Harvard and Yale. Unfortunately for them, David Swensen, the Chief Investment Officer at Yale, calls the fund of funds a “cancer.” Warren Buffett has made a well-publicized bet that one of the largest of these fund of funds will not be able to beat the S&P 500. These legendary investors understand that one simply cannot overcome the layers of fees.

These layers explain why Wall Street has gone from 18% to 41% of the US economy. They exemplify what is wrong with Wall Street and why people are so angry. Americans are not angry simply because some people got rich over the last 20 years; they are angry because they got rich by ripping people off instead of by building real companies that provide valuable products and create jobs that enrich others.

We must get back to the basics. Wall Street needs to focus once again on helping companies access capital to grow, and on helping investors invest in those companies. We must provide investors with direct access to expert investment counsel. The only way that will happen is if investors refuse to do business with the retail arms of the big Wall Street firms. If you are angry about what has happened, then take action and close any accounts you have with Wall Street firms. Then let your anger go before it does turn to hate and then to suffering, because the suffering most likely will be your own.


CHUCK OSBORNE, CFA, Managing Director


Review of Economy

When the consumer stops spending, the economy stops working. Fourth quarter GDP was down 6.3% and the first quarter will be almost as bad. Unemployment is getting all the headlines as it has already reached 8.5% in March, higher than our initial estimates for the peak. Unemployment could go as high as 10%.

As bad as that sounds it is not the worst of our problems. Deflation is the worst of our problems. While there was a slight increase in price levels in February, the trend is still for prices to go down. This is what is driving policy makers at the Fed. While dropping prices may seem good, it really isn’t. If prices continue to fall people will put off purchases waiting for lower prices. Corporate profits will drop leading to more unemployment. To combat this, our government has taken unprecedented steps to reflate prices. Steps including the direct purchase of Treasuries from the Fed and of course the controversial stimulus package. The danger is they may go too far, and reflation may turn into runaway inflation.

Remember the 1970’s? Well get prepared for an exciting trip down memory lane. Double digit unemployment, double digit inflation and double digit interest rates are all very real possibilities once again. However, before that fun can start we have to beat deflation, which believe it or not is even worse.

Review of Market

You must be at least this tall to ride on this market coaster. In one quarter we had the worst January and the best March on record. The S&P 500 ended the quarter down 11%. January started by retreating from the gains in late November and December. Then Mr. Geithner gave his wonderful speech and the market dropped to a 12 year low. Then Mr. Bernanke gave a speech about not nationalizing the US economy and the market had the biggest three week run in 70 years. It is enough to make you motion sick.

The Barclays Capital US Aggregate Bond index was up 1.39% and the Merrill Lynch High Yield Master Index was up 5.26% making high yield bonds the best place to be.

International markets underperformed with the MSCI EAFE down 13.85%, but Emerging markets bounced back strongly with a 14.38% jump in March to post a 1% return for the quarter.

Market Forecast

The record volatility continues to make forecasting even more difficult than usual. We are sticking with our 9% annual return estimate right now, but it could be much better or much worse. The good news for equity investors is that a lot of the bad news is already baked into the cake. March shows that even the mildest of upside surprises can bring a big positive return in stocks, even if the real economy remains weak.

American stocks remain the most attractive in our opinion. We have been right about that for the most part and believe it will continue. We are currently neutral on growth vs. value. Growth outperformed in the first quarter but there was little difference during the rally in March. We keep small caps at a neutral weighting for now, but the outlook is improving as small companies generally lead the rally.

International stocks are a mixed bag. Europe looks awful and getting worse. While some are beginning to question whether all the bad news is already priced in, we remain cautious. China and Brazil are looking better and Eastern Europe looks ready for a possible rebound. We remain cautious in general but are looking at the emerging markets more favorably.

We still believe the opportunities in bonds are in the corporate and high yield bond market. The recent outperformance has legs in our opinion. Treasuries, usually the safe haven, look dangerous to us as eventually rates must go up.