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?

Not much is happening in the markets worth writing about. No news is good news I suppose, but there is one bit of entertainment happening which may be a learning moment. As the golf world readies itself for the U.S. Open Championship one of the PGA Tour’s biggest stars, Phil Mickelson, is under investigation for insider trading.

The FBI and the SEC are looking into allegations that Mickelson got some hot stock tips from a Las Vegas gambler who had played poker with legendary investor Carl Icahn. Icahn supposedly told this gambler that he was about to invest in Clorox and the gambler passed it on to Mickelson. Who knows how this case will end? I am sure it sounds horrible to the layperson’s ears, and that was probably part of the point of making it public after more than two years of investigation had led nowhere. From my perspective the case sounds very suspect, but for our purposes that really doesn’t matter. As it turned out Icahn never gained control of Clorox, and to my knowledge he walked away.

Insider trading is not always everything it is cracked up to be. There are a lot of people out there who just can’t resist the idea that there is some short cut. There are others who are convinced that “it” (meaning pretty much everything) is all a conspiracy. “The system is rigged.” All you have to do is say it and “60 Minutes” will plug your book for you. Icahn and every other big-time investor just makes big bets based on hearsay and then flies out to Vegas to party like Leonardo DiCaprio’s character in “The Wolf of Wall Street,” giving tips to high-rollers who play golf with guys like Phil Mickelson. There is only one problem with this whole fantasy: it is a fantasy.

In real life the most successful investors are more like college professors than Vegas high-rollers. Most do not consider losing money a thrill, and they wouldn’t tell their own mother what their next trade is going to be. Also ironic is that the most successful investors are in no way “insiders.” Most notably Warren Buffett made his fortune in Omaha. Sure, everyone knows him now, but that was not the case when he was picking stocks out of the S&P register while sitting in his living room wearing pajamas. Sir John Templeton said his results improved when he left New York for Bermuda because he was less connected to the noise. Templeton wrote extensively about investing of course, but his favorite subject was actually theology – which is not all bad if your goal is to build a firm as successful as Franklin/Templeton, but probably a little too boring for Hollywood. In his book “More Than You Know,” Michael Mauboussin points out that most mutual fund managers who beat the market over time are not located in large financial cities, i.e. New York and Boston. In fact distance from those cities has a positive correlation with better investment results. One doesn’t need insider information to make good investment decisions, but if you really want some insider knowledge, don’t ask Carl Icahn, or anyone for that matter, what he is investing in next. Ask him how he thinks.

A few days before the Mickelson insider trading story broke I was playing golf with a friend who commented on Icahn’s very public investment in Apple. My friend knew that we had invested in Apple and knew that I had written an Insight about what Apple should do to boost the share price: Return more cash to shareholders and split the stock. He was evidently impressed that people like Icahn had made the same realization. I told him that it happens fairly often – we make an investment for our clients and a little while later it comes out that some big name hedge fund manager made a similar move at a similar time.

My favorite story happened in 2008 when we increased our allocation to U.S. stocks days before Warren Buffett published an op-ed in the New York Times telling people that he had done the same. That same year we invested in Goldman Sachs and a few days later Buffett made his large investment in Goldman. Later we were about to pull the trigger on a railroad when Buffett beat us to it. We joked that we should search our offices for bugs. It shouldn’t be that surprising. We have all read the same books and taken the same math, economics and finance classes. Investing really is not as mysterious as many wish to believe. Understanding value is simply a mindset, which can be trained. When one does so, he is then able to make his own decisions and draw his own conclusions, and he too will find that more famous investors will often be in agreement.

If you really want to get the inside scoop I guess you could fly to Vegas and play golf until someone hands you a hot tip from some famous investor. Or, you could just start thinking like a famous investor yourself. It takes a little more work and may not be as glamorous, but I believe you’ll find it is more rewarding in the long run.

Chuck Osborne, CFA
Managing Director

~Insider Trading