“The difficulty lies not so much in developing new ideas as in escaping from old ones.”
~ John Maynard Keynes

Our instincts on the market downturn seem to be correct. We touched the magic ten percent correction threshold and the market has been rallying since. Predicting the future is impossible of course, but the odds favor a continued rally from this point. There are two questions which we received during the course of this downturn that deserve to be addressed.

The first is, “If you knew the market was going to go down ten percent, why not get out the then back in?” The second related question is, “How are you so sure this isn’t something more serious than a correction?” The answer to the first question is that if we could time that type of thing perfectly we would, but we can’t, and no one else can either. Timing market corrections is a fool’s errand. It is always tempting and it always seems like it would have been so easy in hindsight. That is because in hindsight we see only what did happen and we tend to believe, incorrectly, that what did happen was the only possible outcome.

In reality lots of things could have happened. It is never exactly clear in real time when corrections have begun or when they are over; that becomes clear only after the fact. The market could have bounced back after dropping four or five percent, as happened several times since the last correction. The market could have gone down twelve or fifteen percent; the ten percent rule of thumb only holds true because it is a self -fulfilling prophecy. The text books say ten percent, so people expect ten percent, so the traders come back in at ten percent. It is self-fulfilling, and usually holds, but the few times it doesn’t tend to be bad, so jumping back in just because the market hit the magic ten percent rule is risky. The best thing to do during corrections and in their immediate aftermath is ride them out and look for opportunities to potentially rebalance.

The second question has to do with our fundamental belief in investing from the ground-up, one security at a time. For prudent investors investing is all about the price one pays for the future cash flow one is likely to receive. In the stock market that means the earnings of the companies whose stock one owns. For a bear market to occur there must be a disconnect between stock prices and actual company earnings. In 2000 it was the prices that had gotten crazy. That was a fairly easy thing to predict, although most who predicted it did so two or three years before the actual bursting of the bubble.

In 2008 the prices seemed fine; it was the earnings that disappeared. Those markets are harder to predict. We predicted it in January of that year when unemployment began its rise. The poor market had actually begun in the fall of 2007, but it got worse because the real economy was deteriorating.

This time prices are once again okay, so for the market to really tank, earnings would have to take a big hit. For that to happen the economy must shrink, and that is not happening. Having said that, one of the catalysts for this latest downturn was the International Monetary Fund (IMF) revising their economic outlook downward. That sounds, bad doesn’t it? Until one realizes that the IMF has had to lower their economic outlook 100 percent of the time since 2011 – the approximate end of the European Debt Crisis.

What has happened over the last few years is that the economy itself has been extremely stable. It has been sluggish for sure, but the slow crawl has been very steady. During this same period, however, the forecasts have continued to swing wildly. Central bankers, the IMF, and economists in general have not adjusted to the reality of this slow economy. This is largely due to their unswerving belief in the power of government to steer an economy through fiscal and monetary policy.

Many of those believers call themselves Keynesians, after John Maynard Keynes who was the source of many of their beliefs. Keynes himself had a very nimble mind. In his career as both an economist and a money manager he allowed new information to change his mind. I have often wondered, if Keynes were alive today would he be a Keynesian? I rather doubt it. The man who once said, “The difficulty lies not so much in developing new ideas as in escaping from old ones,” must be laughing in his grave at the idea that his ideas are now the old ones.

Regardless, nothing of substance has changed in our economic reality from the beginning of October until now. Prices are reasonable, the economy is not tanking, and investors are still well-served staying invested.

Chuck Osborne, CFA
Managing Director

~The New Math, Same as The Old

We may finally be getting the long-awaited market correction. The market has been volatile and the momentum is negative. Based on the S&P 500 we are down about 4 percent from the high, still positive year-to-date, mind you, and up considerably over any reasonable period. This leads to several questions, most importantly: Should I be worried?

Most of our clients let us do all the worrying for them – after all, that is our job – but a few always let us know when the market goes down more than a point. They call and say, “I’m watching CNBC and I am getting nervous.” It reminds me of the patient who tells the doctor, “It hurts when I do this.” The doctor’s response is usually, “Then stop doing it.” CNBC is in the entertainment business; they get paid to keep you glued to your seat. Of course they are going to make every hiccup sound like the end of the world. The most obvious example is the ubiquitous headline, “This is the lowest the market has closed since…” It is said with such fervor that you expect to hear them say “…since 1929,” but the timeframe is usually last month. I like the free ticker and find some of the commentary entertaining, but if you get stressed watching then take the doctor’s advice and stop.

Every market drop is not equal. This market has been marching upward for a long time without a breather and a correction is a healthy thing. I have been saying this for a while, but I want to make it clear why the occasional 10 percent drop (which is the official definition of a correction) in stock prices is healthy.  Stock prices are driven in the long term by the underlying performance of the company whose stock one owns. I say this repeatedly and it can’t be said enough:  stock is simply ownership in a company, and over time, the value of the stock will equal the actual value of the company. This is the way prudent investors see the world.

In the short run the price of the stock is determined by what people are willing to pay that day. Traders, unlike investors, see stocks as nothing more than a piece of paper people trade back and forth. Stock prices start to go up as companies do well, and investors benefit from this. Eventually, however, momentum takes over and the traders start buying. They cause the price of the stock to go beyond what the actual company is worth. At that point it becomes difficult for the investor to find anything worthwhile in which to invest. Traders keep trading upward until the market corrects, then they start to panic sell and prices go down, which is the opportunity that investors are seeking.

Let me illustrate it another way. I buy my clothes from a well-known local men’s store here in Atlanta. They are open all year long and people go in there to buy clothes all the time. Twice a year they have a big sale, and that is when I go in there to buy clothes. I get the same clothes for ten to fifteen percent less than the guys who don’t wait.  A correction is a big ten percent-off sale, and when they come it is the time to buy.

Of course the fear in corrections is that they could be more than that. It could be a bear market, which is defined as a twenty percent drop in prices, or worse yet another disaster like 2008. Bear markets happen when valuations get away from reality. That has not occurred. We are still in a bull market, and there is still plenty of reason to be optimistic for the long haul. Bull markets need the occasional correction. So don’t get nervous; if anything it is almost time to get greedy.

Chuck Osborne, CFA
Managing Director

~It’s About Time

While the market just keeps churning and not really moving in either direction, there have been a few significant newsworthy happenings of late. The California Public Employees’ Retirement System, better known as CalPERS, has exited hedge funds; legendary bond manager Bill Gross was shown the door at the firm he helped create, Pimco; and the citizens of Hong Kong are protesting for the right to vote their leaders into office. What does all of this mean?

CalPERS:
It is somewhat refreshing to see that CalPERS still has their rear-view mirror firmly attached and that they are still driving one of the nation’s largest pension funds steadily forward with their eyes focused steadily backward. Our longer-term clients may recall that hedge funds and other so-called alternative investments were a topic of one of our “Quarterly Report” articles  in 2011, “There is No ‘Alternative'”.

At that time CalPERS and other large institutional clients were moving earth and sky to get out of stocks and into anything that claimed to be alternative. They saw in the rear-view mirror that stocks, as defined solely by the stock of large companies headquartered inside the United States, had provided basically no return from 2000 to 2010. In the meantime endowment investors, such as David Swensen from Yale, had made solid returns investing in other types of investments.  So they copied him, except he said they were not copying him, at least not correctly.

Swensen’s genius was not that he just invested in things other than stocks. He invests looking ahead, out of the windshield. In 1999 stocks were extremely expensive, and therefore not likely to fare well going forward. The stocks of small companies did look attractive, as did international companies and real estate, among other things. These investments looked attractive largely because they were being ignored by the rear-view mirror crowd who, in 1999, thought it was a new world where valuations no longer mattered…or at least that was true until March of 2000. That same mentality saw the same suspects crowding onto hedge funds a decade later as if bull markets were never going to return. Of course, by that time those U.S. large company stocks had been ignored for a decade and now looked very attractive.

Almost five years into their big hedge fund experiment, CalPERS is admitting a mistake. The question is, are they making another? The time to hedge may be coming very soon.

Pimco:
It is hard to know if Pimco is one of the world’s largest and most sophisticated money managers or if it is a new reality TV show. Bill, I am sorry to inform you that you have been voted off the island. Yes, we know you are primarily responsible for building the island, and we all appreciate that, but please leave.

I know it must seem strange to those who have followed this story and who do not track managers the way we do. Star portfolio managers usually have large egos. They often are difficult to work with, and believe it or not their departures are often this ugly; but not often this public. I am reminded of when Jeffrey Gundlach left TCW to form Doubleline. That episode involved law suits, alleged pornography and drug use. It makes the Bill Gross episode seem somewhat tame.

Gundlach has gone on to do well as has his old firm, and I’d wager the same will be true for Bill Gross and Pimco. It does illustrate the difficulty of making prudent investment decisions. To do that one must learn to decipher what is important data from what is hyped-up noise. For example, The Wall Street Journal reported that $10 billion had already left Pimco. Think about this: The news broke on Friday morning and by the time The Wall Street Journal went to print Monday morning the infamous “person familiar with the situation” supposedly told The Wall Street Journal that Pimco has seen clients withdraw $10 billion. Pimco manages approximately $2 trillion, and much of that is in income-producing strategies. Frankly it would not surprise me if Pimco saw that much paid out on any given Friday. The same article said one of Pimco’s competitors estimated the total loss of Gross’ departure in a “research report.”  Perhaps research means something else to twenty-something-year-old beat reporters; either that, or the reporter’s editors know that “wild guess” is not going to sell as well as “research report.”

This is noise. It is good to learn to recognize it. We will treat Gross’ departure with the same seriousness we do all manager departures. No overnight “research,” no knee-jerk reactions and no spreading rumors that have no real bearing (and probably are either greatly exaggerated or just not true). This is what prudent investors do.

Freedom:
I always cringe when I see anti-capitalist protests. I cringe because in the vast majority of cases they know not what they do. I remember seeing interviews of the “occupy Wall Street” movement a few years ago in which some of the protesters were asked what they would replace capitalism with, and they stared blankly. They had no idea. Capitalism is the name economists gave to an economy based on freedom. The alternative is a command economy; an economy controlled by central powers. In the real world no economy has ever been completely free – with no rules whatsoever – and not even the Soviet Union could wipe out all voluntary trade, as black markets find their way in when rules get too tight. We live on a continuum either moving closer to freedom or closer to command.

Hong Kong has edged closer to freedom than just about anywhere else. This was especially true before the turnover of authority from Great Britain back to China, but China promised to keep things much the same. China may have a real problem:  Human history shows that economic freedom usually precedes political freedom. People able to control their economic destiny ultimately will want to control their political destiny. Just ask King George about the trouble he had with those New World colonies.

Students now swarm the streets of Hong Kong demanding the right to vote, since they go hand in hand – capitalism and democracy. Unlike those who protested on Wall Street, these students know what they want. They want democracy. This could be the start of something big; or it may not. It may just go away, but this is likely news. We could be talking about these events in Hong Kong long after Bill Gross has been forgotten, and while it may turn out well in the long haul, in the short term CalPERS may want to call back some of those hedge fund guys.

Prudence seems simple, but simple and easy are not always the same thing. It can be difficult to look ahead instead of at the past. It can be difficult to not get swept up in sensationalism. It can be hard to recognize what really matters, and that is what we strive to do every day at Iron Capital.

Chuck Osborne, CFA
Managing Director

~Rear-View Mirror?

~Record Highs!

I promised when we started this electronic newsletter that we would not clog your inbox just because some amount of time had gone by since our last Insight. We write when there is something of meaning that bares commentary. I also promised not to weigh in on newsworthy subjects outside of our expertise, so while this summer has been full of geo-political events, the lack of action in the financial markets has left us, well, speechless. However, at some point the lack of action itself becomes worthy of notice.

Some of the boredom is masked in short-term headlines. The initial estimate for second quarter GDP just came out at 4 percent growth. Isn’t that exciting? Well it is, until you remember that first quarter GDP shrank 2.9 percent, according to what was supposed to be the final number. They revised that number to 2.1 percent in the latest report. So depending on which final number one choses for the first quarter, the first half of 2014 saw growth of somewhere between 1.1 percent and 1.9 percent. In other words, this seemingly never-ending slow-growth slog just keeps going on and the markets seem to have become numb, as if everyone is just stuck in a wait-and-see mode.

Consider the following: First quarter GDP down 2.9 percent; Workforce participation at forty-year lows; Russia trying to take over Ukraine; ISIS on the rise in Syria and Iraq; Rockets hitting Israel from Gaza; Every major investment asset class providing positive returns. Which one of those statements doesn’t seem to fit?

CNBC keeps celebrating new market highs and they keep asking whether this is different from 1999 or if is it another bubble. Well, it is completely different. In 1999 the world, not just the financial markets, seemed a brighter place. The cold war was over. The globe was mostly peaceful. The promise of the Internet was brand new, optimism was everywhere. That is what a bubble looks like. Bubbles are euphoric, this is not. This feels more like a wait-and-see market.

Globally we are swimming in easy money as near-zero interest rates have become the international norm. Most financial historians will tell you that never ends well. They will tell you that easy money is the fuel for most economic destruction. They may be correct, but fuel alone won’t burn; there must be a spark. For inflation as an example, a nation needs a large supply of cash, but it also needs velocity. The money has to move. The fuel needs a spark.

In financial markets that spark is usually what Allen Greenspan called “irrational exuberance.” This market may or may not be irrational, but the one thing it certainly isn’t is exuberant. I’m not even sure it has a pulse.  As we repeatedly said when the market dove during the financial crisis: This too shall pass. The spark will eventually come, and we will all comment about how obvious it is in hindsight. The question remains: Will all this fuel launch us to new heights or consume us?  It is hard to know at this point, and that is why we wait and see.

Chuck Osborne, CFA
Managing Director

~Wake-Up Call?