“I will not lie, cheat or steal and I will discourage others from such actions.” That is the honor code at my alma mater Culver Military Academy. There are similar codes at other schools, and while the language varies slightly, the message is the same:  I not only will act with honor myself but also will insist that those around me do the same. These codes are usually enforced by student-run honor councils that have the ability to punish severely, including dismissal. One can be punished not only for lying, cheating or stealing, but also for not sufficiently discouraging such action, i.e. witnessing an honor violation and not reporting it.

It is interesting that these codes almost always trace back to the military. The Latin word “integritas” is what Roman legionnaries would shout while being inspected. It means wholeness, completeness and entirety. The legionnaire was signaling to his commander that he was whole and ready for battle. It is from this word that we get “integrity.”

I don’t know if they have an honor code at Volkswagen, but if they do, some heads are going to roll. For those who missed it, Volkswagen somehow rigged the software in some of their diesel vehicles to pass U.S. emissions inspections. How does this happen? I have no insider knowledge of this situation; in fact Iron Capital owned Volkswagen in some client portfolios until this came to light. I drive one of their products as do several friends and relatives. However, having spent my career working in and researching large corporations I can submit a very likely hypothesis: This revelation most likely came as a complete shock to senior management. That does not make them innocent, but the conspiracy theorists who are undoubtedly out there are as usual dead wrong. The CEO and board of directors likely did not meet in secret and decide to break the law because they were so greedy that they really want the stock price to completely collapse. What likely happened was some middle-level engineer was told, “Fix this,” and since he couldn’t figure out how to build an affordable vehicle that complies with EPA standards, he cheated. His bosses are likely more guilty of not being curious enough about how things actually get done. They all are likely guilty of caring more about pleasing the boss than living with integrity.

Of course lost in this story will be any question of why U.S. emission standards for diesel engines are so much more restrictive than the restrictions in Europe? Could that have anything to do with the lack of diesels made by the U.S. auto industry? Why was this not discovered by EPA inspectors? We will likely never know. One of the great tragedies of the aftermath of the financial crisis is that there is no accountability given to regulators and policy makers. Greed was and is a convenient and believable villain, which has the benefit of also being factual – there are greedy people in the world – but it is not complete, and therefore lacks integritas.

Just about every asset pricing bubble that has ever popped has taken place after a prolonged period of time with lower than normal interest rates. Yet rates sit at zero seven years after the crisis is over. I have not been critical of the Federal Reserve in the past, but last Thursday’s decision was a poor one. Of course the biggest benefactors of low interest rates are the world’s largest debtors – governments. Could it be that the Fed has the same lack of courage as the engineer at Volkswagen? Could it be that they are just too scared to tell the truth? Sorry, we cannot profitably make a diesel engine that meets EPA standards at the price point demanded for such small cars in America. Sorry, we cannot keep borrowing money for free. Integrity is tougher than it looks.

Towards the end of the Roman Empire the tradition of pounding the chest and shouting integritas was replaced. They changed integritas to, “Hail Caesar!” Seemed like a small thing. That is the trouble with honor codes; it is the second part that gives them strength – using the power of peer pressure for good. It is much easier to just try and please one’s boss.

Alas, we cannot control what goes on around us, we can only react. While integrity may seem like a quaint notion in our modern world, it is this love of truth – the whole truth – which drives prudent investment decisions: the desire to not be satisfied with surface answers, for investment opportunities exist precisely where actual truth differs from perceived truth. That is what we strive to find every day.

Chuck Osborne, CFA
Managing Director

~Integritas!

They say that the road to hell is paved with good intentions – good things that we will get to tomorrow. Take the Federal Reserve for instance:  They are going to raise rates – when your target is set at zero, it is tough to do anything else – but when? It could be on Thursday or they could do it later. The market is currently obsessed with this question. Frankly I think we worry far too much about the Fed, but this current episode does shed light on an all too human tendency.

How did we get here? It has been nine years since the Fed last raised rates. In June of 2006 they increased the Fed Funds rate by 0.25 percent to 5.25 percent. It is now at zero, and if one likes to wallow in hyperbole, then this potential 0.25 percent increase is earth shattering. The rate was lowered, bit by bit, during the financial crisis until it hit zero in December of 2008. It has been at zero ever since.

So, what is all this about? The Fed Funds rate is the overnight interest rate that banks must pay other banks to borrow reserves. Banks are required to hold reserves at the Fed based on their deposits. As deposits fluctuate daily, so do reserve requirements. Some banks will have excess reserves and other will need more, so those with excess lend to those that need to borrow. The lower the rate, the more incentive banks with excess reserves have to take those reserves back and do something more constructive, like loan money to you. The Fed raises and lowers this rate in an attempt to discourage or encourage more lending and therefore more economic activity.

During the financial crisis the Fed, rightly in my opinion, needed to act decisively to encourage economic activity. That is always the easy part. There are basically two economic theories as to how the government can help stimulate the economy: Followers of Keynesbelieve in what we call fiscal policy, which is stimulation by running deficits, either through increased spending, lowered taxes or both. The other school is monetarism, most notably represented by Milton Friedman. Monetarists believe in the power of the Fed.

The problem with both academic theories is that they rely on something called normalization:  After the crisis du jour has passed, policy makers are supposed to go back to “normal.” In fact, if things start going too well then they are supposed to go beyond normal and run surpluses in fiscal policy and raise interest rates in the case of monetary policy. This is where they both fail.

These institutions are made up of people after all, and most of us suffer from this same ailment. We like to put off unpleasant tasks and indulge in instant gratification. We slowly lose control of our waist line as we convince ourselves that we will start working out tomorrow, and that bowl of ice cream tonight will be easy to burn off. We make a budget, then fudge this month saying that we will just cut our budget next month so we can do whatever fun thing presented itself today. Of course the same thing happens next month and before one knows it he is neck-deep in debt.

Policy makers find it easy to come to the rescue – it’s like spending money while eating ice cream. But, the morning comes and we are supposed to get out of bed and go for a run, and pack our lunch to pinch some pennies. It’s tough. The Fed is supposed to raise rates. We do these things because we know we will crave ice cream again; we will want to take that quick trip. The Fed knows that another recession will happen. If it begins with interest rates already at zero then how can they help? It has to act now.

The move will likely be small and likely a non-event. The question is, have they waited too long? Only time will tell…but I really need to get back in the gym.

Chuck Osborne, CFA
Managing Director

~Good Intentions

Making money in a bull market is not a difficult thing. Knowing what to do when the direction turns is what separates the wheat from the chaff. Markets have indeed turned over and the long-awaited correction seems to be in place. So what should one do? What are we doing?

First things first:  never panic. The end of the world has a funny way of never turning out that way. There is indeed life after Lehmann Brothers; Enron and WorldCom did not forecast that all corporations were really frauds; and the stock market has survived recessions, depressions, world wars and terrorist attacks. Not once was panicking a wise decision.

This is much easier said than done, so there are some things that we can do to help – the most important of which is knowing what we own. There are two basic world views on stocks: Some people see them as pieces of paper which are traded the way children trade baseball cards. We see them as what they are, partial ownership in companies. I have no idea how scared people in the first camp must be when the Dow Jones opens for trading down more than 1,000 points. That must be terrifying.

We, however, know what we own. Apple’s business did not collapse Monday morning at 9:30 am Eastern Daylight Time. We realize that this is just a big mistake on the part of irrational traders, many of whom are no longer human beings but computer programs, and this overreaction will be corrected shortly. Having this faith is much easier done when one knows what she owns.

It also helps to have a plan – knowing that there are risk controls in place in your portfolio and professionals ready to act when necessary. This is why we discuss with our clients how much pain they can tolerate. It is much better to focus on risk when things are going well and we are not caught up in the emotion of the moment.

Not panicking is of utmost importance, but it is not the only important issue. Secondly, one must understand that not all losses are created equal. There are short-term trading losses, in which the market moves down because the mood has turned negative. Nothing has changed in the underlying businesses of companies whose stocks are being beaten up; it is just the mood of the market. This is the classic opportunity for long-term investors. The prudent thing to do is wait for some sign of a bottom, then add to the position.

Then there are mistakes. Of course mistakes can happen in any market environment, but they are often easier to see in a downturn. Here one must again fight irrational thought. Tax law in our country says that one cannot write off an investment loss on his taxes unless he has realized the loss: in other words, sold the investment. Many people, including several financial advisers, believe this means that one has not lost anything unless he sells. That is simply not true.

A loss is a loss. If the investment in question is sound, then one can expect to gain it back, and usually much faster than people appreciate. However, as Warren Buffett learned early in his investing career, one does not have to make it back in the same way he lost it. Many times investors are better off realizing the loss so that they can rebalance and better take advantage of the next leg up.

In summary, the steps of navigating a downturn are: Don’t panic. Know what you own and have a risk control plan. Then, be honest about the loss. Where your investments remain strong, use it as an opportunity; where there is weakness, cut losses and look for new opportunities made possible by lower prices. Remember the words of Benjamin Graham, and be greedy when others are fearful.

Chuck Osborne, CFA
Managing Director

~Navigating a Correction

A few years back I was playing golf with my minister. We teed off on the first hole and his drive went straight down the middle, while mine went to the right in long rough and behind a tree. I chopped my ball out of the rough and short of the green, while he hit a nice second shot just ten to twelve feet to the left of the hole. I chipped up to about eight feet from the hole. He made a good birdie putt that just missed and then tapped in for par. I sank my putt for par. We walked off with the same score, but he had hit three good shots and I had hit only one good shot. He put his arm around me and said, “You know, sinking eight foot putts will forgive a lot of sins.”

The market over the last year or so has reminded me of that moment. If one only follows the headlines and sees the returns of the large market indices, such as the S&P 500, then one thinks the market is doing fine. If on the other hand one looks below the surface, she will find that the market return has been bolstered by a few darling companies. Further, most of these companies are making little or no money, but they are hot growers with popular products. The two that really stand out are Amazon and Netflix.

Before I go further let me first say that as a customer of both I am a big fan. Over the last year I have gotten everything from books to underwear on Amazon. Their distinctive boxes sit in front of our house more days than not. We also have Netflix steaming service, which my children can operate all by themselves. They have discovered that the cartoons that were around when their parents were young were far less educational and far more entertaining. My wife and I also maintain the now-old fashioned DVD service, because Netflix is smart enough not to stream the movies we really want to see.

However, as an investor I am not a big fan of paying $276 for $1 in earnings for Netflix, nor do I wish to pay much more for a company that never seems to have earnings at all, even if it is Amazon. The stock of those two companies are up 90 percent and 69 percent respectively over the last year.

Meanwhile stocks of companies that not only earn money but that also pay a portion of that money back to shareholders in the way of dividends have been getting killed. We recently ran some numbers, and it turns out the top ten dividend-paying stocks in the S&P 500 are down more than 18 percent over the last year. None of those companies has a positive return. The top 50 dividend- paying stocks are down 15 percent, and only 11 of those companies have a positive return on their stock.

Sinking eight foot putts may forgive some sins. A few star performers may create the illusion of positive markets, but ultimately all one is doing is trying to keep up appearances and put off reality. My minister and I had the same score on that hole but eventually the player hitting more solid shots is the one who will prevail, and he beat me by more than 10 strokes. A market can only hide behind a few stars for so long.

It appears we may have finally started to see some cracks in this façade:  We could be due for a correction. Corrections are always painful, but they are necessary. There is a reason they are called corrections. Some stocks have already been overly beaten down, while others overly inflated. That needs to be corrected so that we can then re-start this bull market with most stocks participating. Good putting can hide a lot of flaws, but ultimately if one wants the good scoring to continue then he has to hit fairways and greens. Likewise, for the bull market to continue we have to see more companies participating. Correcting these flaws may be painful in the short run, but it does pay off in the end.

Chuck Osborne, CFA
Managing Director

~Keeping Up Appearances

“Sell in May and go away.” That used to be the motto on Wall Street – just cash in and go on vacation for the summer. Of course that is not the best long-term retirement strategy, and for taxable accounts that could increase the tax bill quite a bit. But there is something strange in the water this summer that is almost making us take that silly advice seriously. My children have a case of the summer sillies, and the market seems to, too.

We had the Greece scare earlier this summer. I’m always fascinated with the news coverage of such events. Every investor, fund manager, Wall Street executive, etc., who could be found to do an interview pretty much said the same thing: Greece isn’t the story, it is China. Yet the media outlets sent their roaming reporters to Athens, not Beijing. It bordered on the surreal – Greece voting “no” to get a better deal, only to learn that no such deal existed.

To the extent that China has been discussed it is described as a market meltdown, yet it is seldom noted that the domestic stock market in China was up more than 160 percent before this “meltdown” occurred. I used to joke about no client ever complaining about upside volatility, but it really is true. People do not seem to understand that rapid movements up are just as abnormal and usually just as temporary as rapid movements down. China’s government has stepped in to stop the carnage; anyone found selling short will be placed in jail. That will put a stop to a free fall.

Now the focus is back home and on earnings. Last week Netflix reported:  huge customer growth, still can’t make money but no one seems to care, stock went up over 16 percent. Google reported the next day: beat expectations on earnings but missed expectations on revenues, stock went up more than 16 percent. Apple reports, beats all the way around; stock goes down. Microsoft reports, beats all the way around; stock goes down. Oil supplies are down by 1.5 million barrels over the last two weeks as gasoline demand is “unusually high,” according to the EIA. So the price of oil is again in free fall.

So let’s sum up:  If you are a company with a really cool product that you have yet to figure out how to make profitable, or if you are a cool Internet name with less-than-expected revenues, your stock is up dramatically. If you’re a commodity whose supply is down and demand is up, your price is down dramatically. If you are a company with real tangible products that are insanely profitable, and you do better financially then anyone thought possible, then your stock price is down dramatically. What is wrong with this picture?

Some might say it is the direction of these movements. Companies who do not make money are not supposed to have stocks that go up in value and vice versa. However, Wall Street has always been a little silly this way in the short term. A company is a darling and no matter the reality traders and analysts find something to like, or a company goes out of favor and they find something to hate. That has always happened and always will. The real, long-term issue with what is happening now is the word dramatically. Individual stocks are moving huge amounts on a daily basis.

Happy Birthday Dodd-Frank. Five years ago the massive regulatory pile-on was passed. Proprietary trading of Wall Street firms was a bee in the bonnet of Paul Volcker so he got a rule named after him. No more trading for Wall Street firms. Forget that this had nothing to do with the financial crisis, or that much of the proprietary trading that happened was to serve clients. If one wishes to buy, someone has to sell, and Wall Street firms often would just do it themselves and look for someone on the other side later. That made implementing the rule a little difficult. But this summer it is finally here and in full effect.

Those proprietary trading desks added a lot of liquidity to the market and smoothed out a few rough days. Yes the big firms often made money off their trading desks, but they also made the markets work more efficiently by adding volume and liquidity. It is very difficult to quantify the exact impact, but my experience over the last few years as firms one by one got out of the trading business is that volatility has increased. It is not necessarily higher in the aggregate, as losers and winners still cancel one another out, but the individual movement is much different.

Summertime has always been slow, which means less liquidity and therefore bigger daily price movements. More volatility. It has gotten worse and will likely continue to do so. All the more reason for a prudent investing approach, patience and the understanding that as with our children, so goes the market – summertime is often silly time.

Chuck Osborne, CFA
Managing Director

~The Summer Sillies