The Quarterly Report

  • The Quarterly Report
  • First Quarter 2022
  • Iron Capital Advisors

The Right Way

As I write this, The Masters golf tournament is getting started at Augusta National. The Masters is one of those events that transcends the sport itself. Like the Kentucky Derby and the Super Bowl, one does not need to be a fan of the sport to appreciate the event. For those who are golf fans, watching the world’s greatest live is an interesting and educational experience. One of the biggest lessons to be learned is that there is no such thing as “the right way” to swing a golf club. This is not to say that there is no such thing as fundamentals; there certainly are in golf. However, the true fundamentals are both fewer in number and more subtle than what one might hear at his local driving range.

One may hear that she can’t hit it far if she doesn’t have a big back swing, but then she sees Jon Rahm pound a ball out of sight. Perhaps she will be told that she has to keep her feet firmly planted, and then she will see Justin Thomas dancing all over as he strikes the ball beautifully. We could go on and on, but the fact is, much of what is described as absolute fundamentals are in fact just personal preferences. There is no one right way to swing a golf club.

Some will then take that observation and make yet another false conclusion, perhaps more dangerous than all the other fake fundamentals: They assume that since there is no one right way to swing a golf club, then there is no wrong way to swing a golf club. That is false. As many differences as one may observe on the fairways of Augusta National, there is a common set of fundamentals that every successful golfer must follow. There may be several “right ways,” but that does not mean there is not a wrong way. One will never see a successful golfer who has a fast back swing and slow downswing. There will never be a good golfer whose hands are behind the ball at impact. This list could also go on.

Why is this observation so important today? For the last 25 to 30, years our academic institutions have been taken over by a philosophy known as Post Modernism. The fundamental idea behind this movement is that Truth does not actually exist outside of one’s perspective. In other words, there is no absolute Truth, there is only perspective, so you have your truth and I have my truth, etc. Like all great and horrible lies – the falsehoods that have led to the most suffering in human history – there is an element of truth to this.

In the Eastern religions of Hinduism and Buddhism there is a parable of the blind men and the elephant. A wise teacher asked his students to gather four people who had been blind since birth. It was important that none of the blind individuals had ever seen an elephant. Then each blind person was led to a certain part of the elephant and told to study it with their hands. After a little while each was told to describe an elephant. Of course, their descriptions differed completely depending on what part of the elephant they had felt. One said the elephant was hairy, while another said it had no hair at all. One, who had felt the trunk, thought the elephant must slither on the ground like a great snake, while the one who felt its feet argued that it must walk.

The moral of the story is that our perspective impacts how we interpret things. This is absolutely correct. In our society we often tell a similar story of multiple people witnessing a car accident. If the police interview four witnesses, they will get four different perspectives; the stories will not match perfectly. This, however, is where Post Modernism fails: the four eyewitness accounts may vary depending on perspective, yet if one of them says, “There wasn’t an accident,” then that individual is just wrong. Just because there are multiple “right” perspectives does not mean there is no such thing as a wrong perspective.

Today there are extreme elements on the political left in our country who have embraced a concept known as Modern Monetary Policy. The idea is basically that the government can spend whatever it wants because it controls the money supply, and that it can do so without any negative consequence, i.e. inflation. The theory is wrong. In fairness, this is an oversimplified definition, but this is something academics need to understand: Their theories will always be oversimplified by the politicians who hear only what they want to hear and then use that academic theory as cover for their decisions. In other words, the oversimplified version is what is likely to actually happen in the real world.

One can certainly understand why this theory would be attractive to politicians, especially left-leaning politicians who believe that the government should have a bigger role. They can spend and spend and spend and nothing bad will happen. Why wouldn’t they want to believe this? Unfortunately for them, and for us now, this does not work so well in the real world.

Why? The basic problem with the theory is that it misunderstands what money is and how it is created. The government does not create money, it creates currency, and that is an important distinction. Currency is simply a tool which allows us to live in a society that is far simpler than it would be if we had no currency. In fact, imagining a world without currency is the best way to understand currency.

If there was no such thing as currency, we would still live in a world of barter. In other words, the plumber would do plumbing in exchange for food, shelter, etc. The doctor would be paid by giving him a chicken or a goat, or plumbing his house etc. Everyone would trade what they create for the other things they need. The obvious problem is that the plumber may need a doctor, but the doctor may already have a plumber. This is where currency comes into play. Instead of trading plumbing for medicine, we pay the plumber with money and then he can pay the doctor and she can pay the dry cleaner, etc.

Currency makes our economy work by eliminating the need to find exact trades as we would have to do in a pure barter situation. Historically precious metals were used as currency, but in the modern world we use government-issued paper currency. However, the value is sill created just as it was under the system of barter. The doctor creates value, or money, by providing us with her services. The plumber does the same and so does the butcher the baker and the candlestick maker. The private sector is what creates the value in an economy.

To put it another way, the private sector creates the supply in the concept of supply and demand. It creates the cell phones, computers, televisions, etc. It also creates the beef, fish, and chicken in our grocery stores. All of these items are created by individuals who then want to trade what they create for the other things in life they need. Currency makes that happen, but it doesn’t create the value. The value is created by the individuals who get up and go to work every day in their specific field. These individuals create the supply of goods and services we all want and need.

When government simply issues more currency, doing so does not create more value, therefore the currency begins to lose value. In other words, we experience inflation. To illustrate this, lets imagine that all the value created by the individuals who go to work each day equals 100 units. If the government issues 100 units of currency, then each unit of value equals one unit of currency. A dollar’s work equals a dollar’s pay. However, if the government issues 200 units of currency but nothing changes in the actual economy, then each unit of work now equals two units of currency: Inflation.

Another way to look at it, which is closer to what is actually happening today, is through supply and demand. Supply is the value created by all the individuals working primarily in the private sector. Supply is determined by the level of productivity – how many widgets can one person make in a day. Demand is what those individuals want to consume, and it is determined by how much currency they have in their pockets.

When the government puts more currency in the pockets of individuals while simultaneously reducing supply, they have created inflation. How does a government reduce supply when it is the private sector that creates it? Through tax and regulation. Over the last few years it has been the command to shut down, but that is short-lived and temporary. The biggest long-term issue is the over-regulation, which reduces productivity and the ability to create. The second largest threat is a tax system that penalizes the creation of excess supply.

What does it mean to be rich? It means one has created more than most. The plumber who is able to plumb the most houses will be the one who makes the most money. Of course, there will always be those who are living off money created by an ancestor and not by them. There will be examples of people who obtained money by ill-gotten means. While these are very noticeable and often unfair, the fact remains that most who achieve wealth do so by working harder and/or smarter than others around them. Therefore they create more value for all of us, and as a result get more money.

They should, as the politicians are fast to point out, pay their fair share in taxes. The problem comes from the fact that the politicians never define what “fair share” actually means. When a system is pursued that penalizes these individuals for creating more supply than anyone else, what happens is they cap the amount of supply they are willing to create. Supply is decreased, demand remains, and we all get inflation.

While this is dangerous, it is more talk than anything else. The fact is that politicians love high tax rates because they can then give out valuable loopholes. No one would pay for a loophole if it would be cheaper to pay the taxes. Did I say “give out?” Does anyone ever wonder how individuals who spend their lifetime in politics end up with so much money? I digress, but this does lead to the biggest issue with supply: government regulation. Nothing stops future supply as efficiently as regulation.

We started Iron Capital in 2003. At that time the lawyers made more money than the founders for the first three years. Today, there is no way we could have done what we did. The regulatory burden of our industry is too great and that stops others from entering into the industry. In other words, it reduces supply. That helps firms like Iron Capital as it reduces competition, and it also creates incentive for consolidation. We could sell the firm if we wanted. However, it hurts the consumer.

Where did inflation come from? It came from policymakers simultaneously stimulating demand through government handouts, while also attacking supply. Yes, they attacked supply by shutting down in response to Covid, but they are also attacking supply by increasing regulation and proposing tax regimes that even tax money that has not actually been made yet (unrealized capital gains). Inflation will not go away until this is reversed.

Some will read this and say I’m being political. That may be true in our time, but it did not used to be the case. The philosophy of limiting government interference to allow supply to be created was a guiding principle for John F. Kennedy. It was Jimmy Carter who began the deregulation credited to Reagan. It was Bill Clinton who declared the days of big government over. There is more than one right way. There is plenty of room for traditional political differences of perspective, but that doesn’t mean there is no wrong way. The current path is wrong, and the faster that is realized by people of all political perspectives, the better off we will be. +

Review of Economy

The 4rd quarter 2021 GDP growth came in up 6.9 percent, bouncing back from the 2.3 percent growth in the 3rd quarter. Most of the growth was inventory building as corporations repaired their supply chains. Expectations are for little to no growth in the 1st quarter of 2022.

The official unemployment rate is 3.6 percent in March. Perhaps more importantly, the labor force participation rate is
62.4 percent. This is one percent below the value in February 2020, just before the decision to shut down the economy.

Inflation is 7.9 percent based on the latest consumer price index report. It has moved upward rapidly. The producer price index, which tracks wholesale prices, is up 10.0 percent over the last

12 months. The Fed is beginning to take action, but is it too little too late? +

Review of Market

The markets corrected during the quarter. For the quarter the S&P 500 finished down 4.60 percent, but small company stocks represented by the Russell 2000 index were down 7.53 percent. Value outperformed with the Russell 1000 Value index down 0.74 percent while the Growth index was down 9.04 percent. For small companies the value index was down 2.40 percent and the growth index down 12.63 percent.

Bonds crashed this quarter. The Barclays U.S. Aggregate Bond index ended down 5.93 percent.High yield bonds dropped 4.84 percent. There is no safety in bonds in an inflationary environment.

International stocks rose. The EAFE index finished down 5.79 percent and the MSCI Emerging Markets index ended the quarter down 6.92 percent. +

Market Forecast

The market needed a correction, and it has gotten it. Pessimism is very high right now, and we believe it is overdone. Stocks are the best long-term hedge against inflation which is the biggest economic concern. We should start to climb the “wall of worry” as the market often does.

Value stocks and small company stocks still have more room to run in the long term, but economic growth concerns are growing. International stocks look more attractive than domestic.

Bonds are a problem. Even with large increases in yield that accompany drops in prices, bonds still deliver negative real rates. Until inflation is tamed bonds are worrisome. +