In our last Insight I predicted that after the Fed’s rate hike we would see the market sell off and then rally. We got that part right, but now what?

Is this the final lasting rally or just another short-lived bump? This is when I am supposed to give a bold prediction and hope that I am correct, but the truth is, I don’t know. It depends on the dance between inflation and recession. As I have said previously, the market is not afraid of inflation as much as it is afraid that the Fed will put us into a recession. So, will they?

I have always believed and continue to believe that the Fed gets far too much credit or blame for economic conditions. Sure, interest rates will have some impact, but do businesses really make go or no-go decisions based on a few basis points of interest? If a business venture is predicted to be profitable only if the Fed doesn’t raise rates by a few percentage points, then that is far too thin a margin of error. Perhaps one believes the Fed will be bolder as they were under Paul Volcker when rates peaked at 20 percent in 1981, but there is no indication that this Fed has that kind of courage.

The problem with thinking that economics has become a science is that, unlike real science, there is no control group. There is no way of knowing what the economy would be doing if the Fed had acted differently. We simply observe what the Fed does and then look at what happens. Then we give the Fed credit without much question. I’m not so sure.

Which means I am not convinced that the Fed has ever actually saved the day, nor am I convinced that any Fed other than Volcker’s has ever caused a recession. There are too many other contributors to give full blame or credit to a central bank. Currently we still have a tight labor market, and it is hard to actually go into a recession with a tight labor market.

Consumer sentiment is low, and this has led to downward pressure in the market, but does sentiment really matter? Spending is to the consumer what alcohol is to the alcoholic. When depressed the alcoholic drinks. When celebrating the alcoholic drinks. Mood isn’t the defining factor. Likewise, the consumer spends. When depressed it is “retail therapy;” when happy it is “treating myself.” It may matter in completing a survey, but it does not really matter when adding up economic activity.

In our environment with prices rising, the consumer may spend differently. Gas and food are absolute necessities and will take a larger share of the wallet, but as long as consumers have income, they will spend it. That makes a recession less likely in our opinion. However, a recession can be self-fulfilling prophesy and the more the media fixates on it, the greater the probability of it happening.

In the meantime, we expect the market to stay volatile. Good news brings big up days and bad news big down days while we search for a direction. We remain defensively positioned and ready to move in either direction once a little clarity is gained; this is the prudent thing to do at the moment.

Warm regards,

Chuck Osborne, CFA
Managing Director

~Now What?

The Fed raised rates by 0.75 percent and the market celebrated…before it sold off. I believe we have seen this movie before. Just six weeks ago the Fed met, raised rates as expected, and the market went up; as the market really digested what was happening over the next few days, the market dropped.

Then the market began to climb The Wall of Worry. It rallied right up until the sudden selloff last week and Monday, which once again brought us right back to where we were before the last Fed meeting. We suspect that same pattern will play out: two down days as we head into a long weekend, then the real reaction will take hold.

As a reminder, we have already taken defensive measures in our clients’ portfolios, which are helping. We are watching closely and will take further action if we believe it is necessary.

We still believe that the market is overly pessimistic. The greatest risk factor for a possible recession right now, in our opinion, is that pessimism. Recessions can be caused simply by self-fulfilling prophecy. The truth is that Wall Street is dislocated from the real world, and they often get it wrong in both directions.

These times always seem to last forever as we go through them, but they don’t. This too shall pass, and one day we will look back and be grateful for having owned and continued to purchase stocks at these prices. In the meantime, we must not ignore the market; swimming against the current is not advisable.

As we go into this weekend, it is a good time to focus on what really matters. For all the fathers out there, I hope you have a Happy Father’s Day. Let us also recognize our newest national holiday, Juneteenth. Hopefully this holiday serves a purpose of bringing us together and stopping the constant division. It is a reminder of our nation’s past sins, but also a reminder of what makes us so unique. Every nation sins, yet few if any have fought so hard against their own brothers to right those sins. The United States of America isn’t perfect, but there is no place on earth I would rather call home. I hope you share that feeling as we celebrate Juneteenth.

Warm regards,

Chuck Osborne, CFA
Managing Director

~Fed Rerun

On Friday the latest consumer inflation data came out with inflation at 8.6 percent as measured by the Consumer Price Index (CPI). This was above the 8.2 percent consensus expectation. More importantly, the 8.2 percent expectation represented a continual deceleration in the rate of inflation. Three readings ago inflation had been 8.5 percent, then dropped to 8.3 percent. Now it is at a new short-term high, and this has spooked the market.

In essence this new data has thwarted another attempt at a recovery and put the market back to the previous bottom. We are once again at an important inflection point: Will the bottom hold and the recovery resume, or will we break through and continue to decline? Frankly it could go either way in the short term. We will be watching closely and are prepared to take further protective measures.

In the longer term it is hard to envision the market not being higher one year from now.  The fact remains that we are near full employment and most companies have reported good earnings. So why does inflation have the market so nervous?

It isn’t really inflation that scares the market, it is the Federal Reserve’s (Fed’s) reaction to inflation that scares the market. Market participants fear that the Fed will put us into a recession in their effort to get inflation under control. Market participants are now betting on at least one 0.75 percent raise in rates by the Fed, according to futures markets. These markets have been notoriously bad at predicting actual Fed policy, but that never seems to matter to short-term traders.

In anticipation of these rate hikes (which have not happened and may not happen), The Financial Times reports that 70 percent of academic economists predict we will be in a recession by next year. Will that happen? The key to the recession question is employment. As of this moment the job market is extremely strong and has not shown any signs of weakening. That is the key indicator that we will be following.

These times are always difficult. It is painful and can cause stress, and we understand that. There is one silver lining which may not seem like much now, but in the long-term really matters: The defensive measures we have taken thus far are working. We are not immune to the market, but across the board our strategies are losing less than the market. This matters when the rebound eventually comes, and it will come.

We may still have to take further action in the short term, and if we deem it necessary, we will do so. One simply cannot fight the market. Having said that, we do believe that the market is currently overly pessimistic. Markets overreact; that is what they do. This too shall pass, and we will get through it.

Warm regards,

Chuck Osborne, CFA
Managing Director

~The High Cost of Living

The market has hopefully put in a bottom. One can never know for sure, but the last several days have been encouraging. Still, it has been a very tough year thus far, and that brings up a topic that is worth discussing: How should one judge the quality of an active mutual fund manager?

The obvious answer is to look at the results. How has the fund performed? It seems like a simple question, but unfortunately the answer is not simple. There are countless ways to measure investment results, so this leads to a problem. We have all heard it before:  figures lie and liars figure. A mutual fund’s marketing department can almost always come up with some measurement that will make it look good. What is real and what isn’t?

The usual measure of investment results is the trailing return numbers. We look at a period ending, typically at the end of a calendar quarter or at least a month-end, and look back over time; specifically, we look at the one-, three-, five-, and 10-year periods (if the fund has not existed for 10 years, then we look at since inception). Most have probably not given those time frames much thought, but if one is a geek like me, she may ask, “What is so magic about the one-, three-, five-, and 10-year periods? Why not six-year periods?”

The truth is there is no magic in these time periods, but in 1940 when Congress decided to regulate investment managers, the Securities and Exchange Commission (SEC) had to come up with something. They decided that managers of mutual funds needed to show a consistent measure that could be compared so an investor could make a wise decision. A mutual fund could show more information if they wished to, but they had to show one-, three-, five-, and 10-year results. Further, they had to be calculated using a time-weighted methodology versus a money-weighted methodology, but that may be too much math for one day. Suffice it to say that all the different mutual funds have to do it the same way.

Since that is what the SEC requires, that has become the default method of looking at mutual fund managers and judging their performance. But should it be? There is a problem with using trailing return periods to judge the quality of a manager. Knowing what the return has been for the one-, three-, five-, and 10-year periods that just ended doesn’t tell an investor how the manager got there.

Judging an investment manager is very much like judging a coach. We could use any sport as an example, but the NBA Playoffs are going on so let’s use basketball. An NBA game lasts for 48 minutes. Knowing who won the game doesn’t mean you know how the game went. In these playoffs there have been games where a team got off to an early lead and never looked back, while the losing team was losing for all 48 minutes. There have also been games when one team got off to a hot start and the other team slowly but surely came back, not taking the lead until the very end. The losing team in that game was actually winning for most of the game. The end result is the same, but how they got there was much different.

Why does that difference matter? It matters because there is going to be a next game, and a team that is close to winning but just didn’t finish is a different thing than a team that is being dominated. Trailing results – even the “long-term” 10-year results – are just one time period, like one game. A manager can be winning that game for nine years, have one bad year and lose that particular 10-year game. Conversely, a manager could be losing for nine long years, have one fantastic year, and end up a winner for that one 10-year game. The future prospects of those two managers are very different. When one year sticks out (for the good or the bad), then that year is a fluke. Odds are that both of those managers will go back to being themselves – one who consistently does well and one who consistently doesn’t. However, if all one considers is that one 10-year period, then how would she know which manager is which?

This is why so many people say that it is impossible to select a manager who will outperform in the future: They keep judging them based on just one game. We don’t judge coaches on the basis of one game, and we shouldn’t judge them on the basis of just one season, although fans are guilty of such. Great coaches are identified based on many games, over many seasons in their careers. Likewise, this is how we should judge the mutual fund manager. Iron Capital uses rolling time periods; In other words, we do not look at just one trailing period of time, regardless of how long, but instead look at every trailing period of time. Each month there is a brand new one-, three-, five-, and 10-year period, and it is two months different than the last one. One month has been added and the oldest month has been removed. It can be surprising what a difference two months can make. For those who look quarterly, the difference is six months and that can be meaningful.

Because time periods can be so different, it is important to look at them all. We primarily focus on the manager’s three-year results rolling forward every month; we then average those periods to see how the manager has done on average. It resembles looking at a coach’s career versus focusing on one game, and it is far more valuable. It tells us with a fairly high degree of certainty whether this manager is good, or if has he just been lucky lately.

It is also important to note what it doesn’t tell us: It does not tell us that this manager will outperform in the next game. Nothing can do that, and there are many in our field who mistake that fact with not being able to judge talent. What our process tells us is that this manager is a quality manager and therefore our odds of doing well over time are good. Rolling time periods is only the beginning for us, but it is an important beginning. It identifies consistency. It also helps us know when we should be patient with a manager who just had a bad game. Everyone has those from time to time, it cannot be avoided, but quality managers bounce back.

With the market down so dramatically, we will see managers who stumbled, and we will see some who did well, at least relatively. It is easy to judge them after just one period, but that is no way to make prudent decisions. At times like this we need to know that the people managing the mutual funds in which we are invested are actually talented, that they are good at what they do. Trailing returns, no matter how long, can’t tell us that; we have to dig deeper.

Figures lie and liars figure. It isn’t enough to consider only a trailing return number and then think we can judge a manager. We need to understand the how and why, and one cannot get that from simple trailing returns. That is an important lesson anytime, but extremely important in this environment.

Warm regards,

Chuck Osborne, CFA
Managing Director

~Figures Lie and Liars Figure: Manager Edition

“It’s a dog-eat-dog world, and I’m wearing milk bone underwear.” – Norm, “Cheers”

It has been one of those years thus far. We are in a dark cloud. Inflation has come back, even though we learned this lesson in the 1970’s. We have an actual war going on, as in one nation invading another. The stock market has gone past correction and into bear market territory. More importantly, the bond market has produced historic losses.

Through Wednesday, May 11, the S&P 500 is down 17.03 percent year to date, with many areas of the stock market doing much worse. Normally in times like these the bond market would be rallying as investors fled stocks and moved into bonds to reduce risk, but not today. I know I sound like a broken record, but stocks actually do act as the best hedge against inflation in the long run. The problem thus far this year is that inflation is accompanied by fear of recession.

Bonds are usually a hedge against recession fears, but the problem this year is that recession fears are accompanied by inflation. Inflation destroys bonds; the reason for this is self-evident if we take the time to remind ourselves that bonds are simply loans. If we borrow money at 3 percent interest, our loan payments would be attractive income for an investor when inflation was nonexistent. With inflation at 8.3 percent, that 3 percent interest payment now represents a 5.3 percent loss of purchasing power. Bondholders are actually losing money when inflation is considered. So, they are selling, and as a result the U.S. aggregate bond index is down 9.5 percent year to date through May 11.

For the stock market to recover from a 17 percent drop, we would need a 20 percent rally. This happens in the stock market frequently and would be easily done. For the bond market to recover, we would need a rally of 10.5 percent. It could happen, but it is not likely. The yield on the 10-year Treasury bill is trading in the neighborhood of 3 percent. That means the most likely return on those bonds is 3 percent. In other words, stock investors are experiencing short-term pain, but will recover and move forward in all likelihood. Bond investors have no such prospects.

To add insult to injury, many bond investors are retirees who are counting on that income to fund their retirement. They have already had to settle for historically low yields, which has reduced the income possible from the traditional bond approach. Now the people who failed to adapt to the low-interest world we were living in are getting punished more than anyone else.

So where is that silver lining I mentioned in the title? Iron Capital did adapt, many years ago. Our approach to producing retirement income is unique, and it has held up well. Year to date, the average of our income portfolios is still down 6.34 percent, but that is much less than traditional income portfolios, and our approach also provides an opportunity for recovery. We build portfolios that produce the income needed, or as close as possible, while taking the least amount of risk possible; over the last several years that means we have been focusing on dividend-paying stocks. These have been in places like energy, utilities, consumer staples. The areas that have done the best in our current environment.

This was not some sort of miracle foresight; no, we just followed our process, and that process led us to portfolios that many would describe as more risky than traditional bond-heavy portfolios. That is because many are stuck defining risk as either legal structure or volatility. Risk is losing money, and our approach to investing during the most risk-sensitive time in one’s life has held up much better. That is a silver lining in this dark time.

I know, some are reading this and saying, “How does that help me, I’m still trying to accumulate for retirement.” I feel that pain, and times like this are always painful, but they will pass, and the stocks will rise again. It always happens faster than one thinks possible. Meanwhile we will do what we can to protect our client portfolios. One day you will be retiring yourself, and it is good to know that it can be done, even in an environment like today’s.

Warm regards,

Chuck Osborne, CFA
Managing Director

~Silver Lining