Our presidential political season is now in full swing, and what an odd run we are about to have. It is often said that our political choice is a choice between the lesser of two evils; this year that seems especially the case as the two mainstream party candidates are polling as the least popular ever. Both candidates have been accused of being loose with the truth. I think New York Times columnist David Brooks said it best when he said that we seem to be living in a post-fact era.

He has a point. One would think that in the information age it would be harder for politicians to get away with fudging the truth. After all, we live in the era of instant fact-checkers. However, that is not the case, and I for one blame postmodernism. For those who are not familiar, postmodernism is the idea that truth is in the eye of the beholder. You have your truth and I have mine. This is contrary to the modern view which led the Western world out of the dark ages and up to the 1960s. Modernism believed truth existed on its own, independent of what you or I or anyone else thought. In a postmodern world if I believe the world is flat and the sun revolves around it, then that is my truth, facts be damned.

Worse than ignoring facts, this post-modern mindset is more likely to abuse them. It is a fact, after all, that the sun rises in the east and sets in the west. So I’m right, the sun obviously revolves around the earth. Except that it doesn’t. Facts taken out of context can be just as misleading as blatant falsehoods.

One great example of this is when people talk about what the stock market has done under one party versus the other. It doesn’t matter what party the president hails from; what matters is what policies actually come out of Washington. It didn’t matter that Kennedy was a Democrat and that Reagan was a Republican; what mattered is that both lowered taxes and the economy grew. It didn’t matter that Roosevelt was a Democrat and Nixon a Republican; both tried price controls and they both failed. (Price controls always fail, but that is a topic for another day.) It doesn’t matter that W. Bush was a Republican and Obama a Democrat; both never saw a regulation they didn’t love, and both saw inequality increase dramatically.

Taking facts out of context is not limited to politics. The investment world is increasingly being driven by facts taken out of context. My favorite recently has been the drumbeat of, “We are at record highs.” This is factual, however: it ignores that we have basically been at the same point for almost two years now. It also ignores that the valuation spread between the most expensive stocks and the cheapest is the largest it has been since the tech bubble of the late ‘90’s, and finally it ignores the rest of the world.

To search for truth, one cannot just look at random facts. One has to take facts in context and have a rational theory as to how these facts all relate. Milton Friedman, the late Nobel Prize-winning economist, used to say that we must reject theories without facts and we must reject facts without theory. Sometimes the stock market goes up or down during a President’s tenure based on nothing but coincidence.

If we want to know the truth about the market, then we just can’t look at the headline U.S. indices. We have to see the context. Most stocks in the U.S. have not done well over the last year, and stocks globally are even worse. Things have not been as good as “record highs” suggest.

Of course every cloud has a silver lining. This also means that those who are now talking about how expensive the market is and how overheated it may be are most likely wrong. At Iron Capital we do not see a market downturn in the immediate future. Much more likely in our view would be a reversion to the mean, which would say that stocks that are expensive need to be cheaper while cheap stocks rebound. The S&P 500 may be expensive with a price-to-earnings ratio near $20, but our core portfolio has a price to earnings ratio of $11.50. Cheap stocks are there to be had and that bodes well for investors going forward, regardless of which party is in the White House, or record highs, or any other random fact taken out of context. And that’s the truth.

Warm regards,
Chuck Osborne, CFA

~Seeking Truth

Yesterday I was watching interviews of people in Britain leaving the polls. The reporter asked one gentleman, who had voted to leave the EU, why he thought older voters were more inclined to vote “leave” than younger voters. He responded, “They have been in the EU their entire lives. They don’t remember life before the EU.”

Recapturing the glory days: This is a political theme that is driving decisions everywhere. People don’t like the post-economic crisis world and they want to turn back the hands of time. The people of Great Britain want to be free of the European Union (EU). They are, after all, a proud nation. Those of us who were born in the United States after World War II often fall into the trap of thinking that the U.S. has always been the great world power. The international language of business is English, and I have been told many times from intelligent people that this is because of America. But, that is incorrect. English is the international language because of the English. They built an empire on which the sun never set – an empire greater than Alexander the Great, greater than Caesar, greater than the Mongols or the Russians. An empire that peaked in population not in some far-off ancient time, but in 1938.

The reporter did not ask the gentleman his age, but I would guess that his parents were alive and well in those days before the second Great War. I would assume he has good memories of Britain before the EU, and probably some romanticized memories of the stories his parents told him about Britain’s glory days. Somewhere in his head he believes that if we just leave the EU, then Britain will be free to live those days again.

Are we that different? Many sociologists have suggested that America’s great political divide is two competing romanticized visions of the U.S. in the 1950s:  Conservatives long to return to the days of traditional marriage, regular church attendance and a feeling of being safe in one’s community, while liberals want to return to a day of incredibly high tax rates and invasive regulation.

The problem is that one cannot go back. Dealing with the present is one of the hardest things for humans to do. We tend to dwell in the past or worry about the future, or both. It is hard to actually focus on now. This is certainly true in my world. Prudent investment decisions are made in the now. The past is past; good or bad, it is what it is. The future is unknown. Now is the only moment over which we have any control.

This brings us back to the Brexit. Now that Britain has voted to leave, what will be the real impact? There are lots of doomsayers out there, and the initial market reaction has been very negative. The reality is likely to be far less brutal. Some of the “leave” voters are likely to be disappointed. The British Empire is not going to magically rise from the ashes. Last century’s manufacturing jobs are not going to return.  You can’t go home again.

As for the doomsayers: As of today, absolutely nothing has changed. Yes, change is coming. Britain has two years to renegotiate trade relations with the EU countries. Some of those countries may be mad now, but it is unlikely that they will hold a grudge for two years. New trade agreements will be negotiated. Britain needs German cars and Germany needs Britain’s banks. Over the next two years they can hopefully work out new agreements.

In the meantime, should the short-term sell-off continue for more than a day then opportunities will be there for the taking. As we said before the vote, Brexit will not cause Apple to sell fewer phones or Coke to sell fewer drinks, of Ford to sell fewer cars. Prudent investing is done from the ground-up. It is also done in the now.

Now is time to be patient.

Warm Regards,
Chuck Osborne, CFA

~You Can Never Go Home Again

When I was young my Mom always told me, “If you don’t have anything good to say then don’t say anything.” When we started writing these Insights in the midst of the financial crisis I made a promise: We would only send an Insight out when there was actually something worth writing about. Some have asked why we have not sent an Insight in a few months; well, there really has not been much to say.

There is a lot of noise; there is always plenty of that, but there has not been much news. That could change next week. The citizens of Great Britain get to decide whether or not they stay in the European Union.  The media has deemed this the Brexit. The markets, which have ignored this story for months, have all of a sudden decided to pay attention. Polls in recent days suggest the vote may be closer than people previously thought.

If this story sounds somewhat familiar it may be because we had the running saga of Greece and its referendums. Should they leave? Should Germany kick them out? Closer to Britain we had the vote of Scotland to decide if they wanted to leave Great Britain. Based on the underwhelming popularity of our two Presidential candidates I would not be surprised to see this episode play out in the U.S. I still remember when Key West tried to become its own country.

The story is the same every time. People think that the vote really won’t be close, after all staying is a no-brainer. The polls then show the vote is closer than originally thought. Panic sets in – lots of people evidently do not have brains! – then the real vote takes place and it turns out as expected. People with brains win!!

Here is the problem – it is a little like the boy who cried wolf: Every time he did it, people got less and less scared until the real wolf came and no one helped. If we keep having these votes, eventually those who wish to sever ties with the rest of the world will win. I seriously doubt that happens next week, but what if it does?

There have been countless events that have been billed as the end of the world and yet we are still here. Britain leaving the EU will not cause the planet to spin off its axis; in fact, its impact will probably be smaller than most might think. There will be short-term trading headaches, but European companies will still want to sell goods to Britain and those things will get worked out. The fear is more about the potential domino effect. What if France is next?

We believe that fear is overblown. So overblown that Germany now has negative interest rates. If one wishes to loan money to Germany today, then they will get less than 100 percent of their money back. Japan has been that way for a while now and this week, with the fear of the Brexit, Germany has joined them. This is not a healthy environment; it is not good when investors willingly sign up to take a known loss. The only rational reason to do this is that one believes that he will lose more in any other investment over the next 10 years. That is an incredibly pessimistic assumption.

In a world like this it becomes all the more important to invest prudently. That means from the bottom-up. There is always something on the global geo-political stage that threatens long-term economic growth, but that doesn’t mean Apple will sell fewer iPhones, or that Coke will sell fewer drinks, or BMW fewer cars.

At Iron Capital we don’t invest in markets or in countries or in economic and political unions. We don’t bet on political unions staying together or breaking up. We invest in companies – companies that sell products people need and want regardless of whether or not Britain is part of the EU. The Brexit, if it even happens, will cause some volatility but it will not change the long-term viability of any of the companies that we own, directly or indirectly through mutual funds.

Investing is hard not because it is complicated. In truth it is very simple. It is hard because there are so many distractions, so much noise. I hope you understand why we have been hesitant to add to that volume.

Warm Regards,

Chuck Osborne, CFA
Managing Director

~If You Don’t Have Anything Nice to Say…

Markets are unpredictable in predictable ways. This malaise which set in at the beginning of this year just won’t go away. Even with the benefit of some positive days and even weeks, this selloff isn’t over yet. And it won’t be over until we get a capitulation.

Capitulation is the last emotional stage of every market cycle. Markets go up on apprehension, grow on optimism and peek on exuberance. They begin the downward leg of the cycle on denial, fall on fear, and finally hit bottom once people have capitulated. That is the pattern. It is easy to recognize in hindsight, but not so easy when we are in the midst of things.

We are not there yet. Everyone is in a bit of a funk, but I’m not sure I would call it fear. No two downturns are exactly the same, but this one reminds me a bit of 1998. In 1998 I had not quite lost all my hair but was getting close. The hair on the sides was a little less gray. Russia was in big trouble. The giant hedge fund, Long-term Capital Management, which had not one but two Nobel laureates on staff, was collapsing. Asia was having a financial crisis. We, however, were just fine, except for the stock market.

It isn’t exactly like that now, but there are problems out there in the broad world. China is growing more slowly; oil’s plunge is hurting many commodity-based emerging market economies; the developed world is already stuck in a slow growth rut brought on by too much debt. We keep slogging along, but not fast enough to hold up the global economy.

Having said that, unemployment has gotten much better. Low oil prices may be rough on oil companies and emerging market countries but it is pretty nice for the average person commuting to work who now has a few extra bucks in the pocket to use elsewhere. That isn’t a bad thing. We are just fine.

Most stocks are not expensive. We have talked about the fact that last year’s market was dominated by very expensive stocks flying high, but when one looks beyond those few, the rest of corporate America is on sale. That is a good thing for longer-term investors.

There seems to be a consensus that this early year selloff has been overdone from the start, so why won’t it just go away? Well, this selloff has nothing to do with investors. It has been driven from the start by speculators, mostly computerized speculators, and they will not stop selling until they see a sign: Capitulation. The big wash-out. It is knowledge like this that makes trying to time the market so tempting. Everyone knows it has to happen.

The problem is there is no set schedule. We could have another rally like the one we had in the fourth quarter (which in hindsight seems like a false rally) before falling again, or it could happen tomorrow and be over by week’s end. This is why timing never works.

No, all the prudent person can do is check and double check the quality of her holdings and take comfort in the knowledge that this too shall pass. What we own is solid and will be valued higher within a relatively short period of time.

Hindsight is an interesting thing. The market downturn in 1998 seems like just a blip now, but it didn’t when we were in it. That feeling, that this will last forever, is what eventually brings on the very capitulation which then leads to the next leg up. Waiting is the hard part. But this will indeed pass.

Chuck Osborne, CFA
Managing Director

~Capitulation

History will look back at the aftermath of the financial crisis of 2008 as a glaring example of the dangers of reactionary regulation. Don’t get me wrong; regulation – rules, if you will – is absolutely necessary, but like many things in life it needs to be treated with respect. The danger in regulation is the regulator. Who is regulating them? Who is holding them accountable?

To believe that they had no role or responsibility for what happened is to be either incredibly naïve or completely partisan. I’m not defending the behavior of bankers; I am simply stating what should be common sense, that there was plenty of blame to go around. Why is this important?

It is important because the reaction to the financial crisis gave us new regulation, which instead of replacing or fixing things that were really wrong simply attacked phantom villains, such as proprietary trading. People were mad when some Wall Street banks profited from the downturn as they had taken positions that were opposite of many of their clients. But, that is what they are supposed to do – they are broker-dealers, their goal was to give their clients what their clients wanted. If a client wished to buy something, the banks are supposed to either find someone else who wishes to sell (broker) or sell it to them themselves (dealer).

The banks also made markets in the securities that they sponsored. They stepped in when people wanted to sell quickly and when they wished to buy quickly. They made markets work more smoothly. But, as fate would have it, clients often want to sell and buy at exactly the wrong times, so the banks often profited. That supposedly had to be stopped.

This brings us to the worst market start of any calendar year in history – 2016. There are lots of excuses given for this selloff. The first was geopolitical tensions; that has gone out of the headlines and is no longer even being discussed. The second is China and its economic slowdown, but that has been going on for a few years now and even it is starting to grow weary.

The third excuse has been oil. The most honest thing I have heard on the oil story came earlier this week from Morgan Stanley. Their oil analyst was on CNBC and came out and said flat out that the price of oil being set in the market has become completely dislocated from the actual, real world supply and demand for oil. It is all speculation. The oil price is not forecasting some economic doom, it simply reflects the whims of traders, more and more of whom are not even human beings.

All these things may be contributing to a poor start to this year, but none of them equate to the worst start in history.  The truth is that volatility is much higher just because there is no one willing to step in and be on the other side of a trade on any given day. The computers, who are now ruling the daily trading, are either buying or selling. If they are buying, then whatever they are buying is going to be up huge; if they are selling, then whatever they are selling is going to be down huge. Every move is being greatly exaggerated because all the programs are the same and they are all doing the same thing.

Over the last several months this market has really just been stuck in a giant trading range: it goes up, then down, then up…but it is really going nowhere. That is not unusual. What is unusual is the size of the ups and downs. The market is not functioning because no one has stepped in to be the bank. If no one is willing to buy when most are selling or sell when most are buying, then the daily price movements will continue to be exaggerated. This brings me back to my original question. Do you miss proprietary trading yet? I know I do.

This is not the end of the world. The market has always been a voting machine in the short term but a weighing machine in the long term. I do not believe that these exaggerated movements will change that; they just make the ride that much bumpier.

I would love to see real reform to fix the mess we created in an emotional knee-jerk reaction to the financial crisis. Maybe instead of simply reacting to each crisis du jour, we could rewrite the whole rulebook in a way that actually makes sense. Not likely, but we can dream can’t we?

In the meantime, we focus on what is real and what we control. The ride has become rougher but the destination has not changed. This selloff will end and a new rally will begin. Three steps forward and two steps back.  We know what we own and why we own it, and those factors did not change with the change of the calendar. Patience will be rewarded.

Warm Regards,
Chuck Osborne, CFA
Managing Director

~Miss Proprietary Trading Yet?