The Quarterly Report

  • The Quarterly Report
  • Fourth Quarter 2011
  • Chuck Osborne

We’re Making Good Time

WHEN I WAS A KID, my family took a lot of road trips. We went to the beach, to Disney World, to visit relatives …always in the car. Most of the time my mother, my siblings and I would fall asleep while Dad motored down the road. When we woke up, we always asked the same question, “Where are we?” My father would always respond, “I don’t know, but we are making good time.” Well, I have good news and bad news. The bad news is that most people believe America is headed in the wrong direction. The good news is that we are making good time. I have seen these polls for years: Anywhere between 70 to 80% of us think our country is headed in the wrong direction. But, has anyone asked in what direction we are heading?

I came up with the idea for this newsletter while waiting inline to go through security at the airport shortly after the 10th anniversary of 9/11. I was thinking about how our country had changed since 2001, and I had been reading an article inThe Economist about Russia. According to the article more Russians want to leave Russia now than at any time since the collapse of the Soviet Union. Standing in the winding line preparing to partially disrobe for security I couldn’t help thinking, “Was traveling the Soviet Union any more difficult than this?” Intellectually I know the answer is yes; we may feel harassed by the new security measures, but we can still go wherever we wish in this country.However, standing in that crowded line being herded like cattle, it hit me: we are less free today than we were 10 years ago, and we are heading in the direction of increasingly less freedom.

When I began research for this article I thought I would talk about how increased regulation has slowed economic growth and created uncertainty, and therefore decreased investment returns while increasing volatility.However, in doing the research and paying attention to every mention of new rules, I began to realize this issue is much bigger. Every day I was printing off two or three articles about some crazy regulation or law. The examples are too plentiful to list, but my favorite was a family in San Juan Capistrano, Ca. that was fined for having a Bible study in their home because a local ordinance prohibits groups of three or more from gathering without a permit. I think that bears repeating: There is a city in the United States of America where it is against the law for three or more people to gather.

In 2000, the United States ranked third in the world in terms of economic freedom, behind Hong Kong and Singapore,according to the Index of Economic Freedom published by the Heritage Foundation and The Wall Street Journal. We have dropped to tenth and our momentum continues in the wrong direction.

According to a recent article in The Wall Street Journal there are 4,500 federal criminal statutes. This does not include the300,000+ regulations that are not in the federal code but that can carry criminal penalties including prison. I want to make it clear that I do not believe any rational person would want to live in a society with no rules or laws. But, how many laws do we really need? Moses came down from Mt. Sinai with ten, and Jesus said the ten really can be summed up in two, the second of which is known as the Golden Rule: Do unto others as you would have them do unto you. It is universal, and some variation exists in all mainstream religions and/or philosophies.Going to one law may be a little too simplistic, but somewhere between one and 4500 there has to be a happy medium, and my guess is that it is closer to one than to 4500.There is substantial evidence that more laws and more regulations can be counterproductive. Hans Monderman may not be familiar toyou, but he is as famous as a traffic engineer ever gets. He was a Dutch engineer who realized that most modern safety infrastructure –warning signs, traffic lights, guard rails, curbs, painted lines,speed bumps and so on – is not only often unnecessary, but can actually endanger those it is meant to protect. His favorite maxim was, “When you treat people like idiots, they’ll behave like idiots.”

Monderman made his name in the provincial city of Drachten. In the center of town was a congested four-way intersection that was dangerous and constantly overcrowded.He removed all the lights and every other traffic sign he could without violating Dutch law, and replaced them all with a radical type of roundabout,which he called a square about, marked only by a raised circle of grass in the middle and several fountains. After his transformation,congestion decreased and, more remarkably, the number of accidents per year was cut in half. By doing away with the signs and lights he actuallym ade drivers think, and by forcing people to think, he made the intersection safer while improving traffic. Interestingly, surveys found that locals perceive the intersection to be more dangerous after the changes,even though the evidence clearly shows the opposite. That was music to Monderman’s ears. In an article for The Wilson Quarterly, he said that if they had not felt less secure he would have changed it immediately.

Regulations are usually brought forth in an effort to protect people.The great example of our time is the duo of Fannie Mae and Freddie Mac,whose entire purpose was to grow housing by bringing a quasi-government guarantee of mortgages, which made investors feel like mortgage securities were “almost as safe as treasuries.” That false sense of security was a major contributor to the housing bubble and ensuing crash. If investors knew how risky mortgages could be, their behavior may have been different.

This is not the only problem that regulation brings forth. As Milton Freidman points out in his 1962 classic, Capitalism and Freedom, regulation goes hand in hand with inequality. Regulation by definition directly impacts a targeted group; however, the costs are spread through the masses.This creates a dynamic where you have a highly motivated, organized and usually well-funded minority that wishes to bend regulation to their favor versus the majority, which is largely disinterested in any one particular regulation. Increasingly regulation is drafted to favor the politically connected and motivated, often at the expense of the majority. There has been a lot of talk about the growing inequality in the United States,but little intelligent discussion of its actual cause. I contend that it is not a coincidence that inequality in our society has grown hand-in-hand with regulation.

The great equalizer in America’s past has always been social mobility –the American dream of rags to riches in a generation. Historically we have not held a poor opinion of the wealthy because most of us believe they must have done something to deserve their wealth, and we hold the belief that we can one day join them if that is an aspiration. The more regulated our society becomes, the less possible this becomes. Regulation first and foremost protects the status quo.
Eric Schmidt, executive chairman of Google, summed it up when he told theWashington Post, “…[R]egulation prohibits real innovation, because the regulation essentially defines a path to follow – which by definition has a bias to the current outcome, because it’s a path for the current outcome.”The explosion of innovation in the internet happened because the internet was new and therefore largely un-regulated. If it had not been for the deregulation of the phone system it is very probable that there would be no internet today. No Google, no Amazon, no Facebook, and certainly no iPhone to access all the aforementioned.

Regulation inhibits competition, especially competition from a completely new innovation. Take my industry as an example:The more regulated the financial industry becomes, the more difficult it becomes for the Iron Capital’s of the world to compete with the JP Morgan’s of the world. There is no amount of regulation with which JP Morgan, Goldman Sachs,etc., cannot afford to comply. There will be a point when independent boutiques like Iron Capital will no longer be able to stay in business as stand-alone entities. This protects the status quo and prohibits real reform, which would come from more customer-friendly competitors.

This is why we see industries and specific companies spend a fortune in lobbying politicians; they do it to shape regulation to give themselves an advantage. This is the cronyism that has so many people upset today. Look at the banks: The crisis of 2008 was supposedly caused because some financial firms had become “too big to fail.” The story goes that they were un-regulated and out of control, So Dodd-Frank passes with the mother load of new rules, many of which have not yet taken effect. Today there are already fewer national banks and the ones remaining are significantly larger than they were in 2007. If they were “too big to fail” then, they must be “too bigger to fail” now.

Regulation also leads to deterioration in ethics. In 2011, we saw the collapse of financial derivatives broker MF Global,which evidently stole up to $1.2 billion from their clients. Ina heavily regulated environment the mindset often becomes,“What can we get away with?” As opposed to, “What is the right thing to do?” Jon Corzine, the former governor of New Jersey and CEO of MF Global, testified before Congress thatall of his actions were legal. He was assured of this by his operations staff. If Jon Corzine simply had to ask himself,“How would I feel if someone stole my money out of my brokerage account?” as opposed to “Is there a way we cando this and have it be legal?” then MF Global clients would be $1.2 billion richer today. The very fact that he felt the need to verify what he was about to do was legal shows how compliance with a web of regulation ends up substituting for simple ethical judgment.

If the growth in regulation goes far enough, we end up in a situation where regulatory compliance is a matter of figuring out which rules the regulators are actually going to en forceand which they are not. It is a short step from there to bribery being the only way anything can get done. Regulation is the yeast of corruption.

This is the direction the United States is going. We are becoming more regulated and less free. We show all the known symptoms: Social mobility has been decreased;inequality has risen; cronyism is the way to success. These are the attributes of a regulated society. The question is, willwe realize this and actually change direction, or will we just continue down the same path, knowing something is wrong but simply blaming “government” or “Wall Street” instead of seriously asking what is it that is wrong and what can be done to fix it? Will we see the wisdom of Monderman, that sometimes less is more? With freedom comes responsibility and personal accountability. If we once again embrace it, we may well find that life is actually safer and more fair without all that safety apparatus.


Charles E. Osborne, CFA, Managing Director


Review of Economy

It all depends on expectations. We are in a recurring pattern. We get some good economic news, expectations rise, then the news does not meet expectation, then expectations fall. The economy is slogging along, but the expectations keep moving wildly. We are once again at a point of relatively high expectations. Unfortunately we believe this will only lead to disappointment.

Unemployment has gotten better with the rate dropping to 8.5%. It will be interesting to see if these end up being permanent gains or just a seasonal blip. We are hoping for the former but we have seen false starts before. The real question for 2012 is Europe. If they are somehow able to avoid a major disaster – a bank collapse and/or sovereign default – we could see positive growth. The risk is that a severe recession in Europe spills over to our shores.

Review of Market

The S&P 500 rebounded from the painful 3rd quarter and was up 11.82% during the 4th quarter. The volatility continues and what ended up a flat year for the major headline index was anything but stress free. Small caps did better in the quarter but finished the year down 4.18%. The year was especially tough for managers who care about corporate fundamentals because the volatility was driven by geo-political forces and what was going up or down at any given time was seldom logical.

Bonds continued their positive momentum and ended the year as the best asset class. We entered the year with low interest rates, and US Treasuries were downgraded. Still, bonds proved to be the safe haven of choice as the European debt crisis intensified. The Barclays US Aggregate Bond Index was up 7.84% for the year.

International markets were the worst place to be, as the European crisis is the big news of the year. The MSCI EAFE was down 11.73% for the year, and emerging markets did even worse down 18.17% as measured by the MSCI Emerging Markets index.

Market Forecast

Our outlook remains negative. There is some positive momentum heading into this year, but the risk of a major market jolt – a major bank collapse in Europe, a war with Iran, a failed bond issuance by Italy – seems great. If we avoid such an event we could see modest gains but if one of these risks materialize we will see sudden and extreme losses. Our best prediction is that the markets end the year flat with more extreme volatility. Caution remains in order.

Our outlook remains negative. There is some positive momentum heading into this year, but the risk of a major market jolt – a major bank collapse in Europe, a war with Iran, a failed bond issuance by Italy – seems great. If we avoid such an event we could see modest gains but if one of these risks materialize we will see sudden and extreme losses. Our best prediction is that the markets end the year flat with more extreme volatility. Caution remains in order.

Bonds look troubling over the long haul but will likely remain a safe haven during times of crisis. Commodities will depend greatly on oil and the tensions in the Middle East.

The biggest risk to our outlook is that Europe does somehow muddle through without a big incident. In that case, we would rather risk making less in an up market than losing more in a down market.