Ben Bernanke has spoken again, this time to clarify that he did in fact say “if:” The Fed will begin tapering if the economy continues to improve. Markets are up across the globe, because improvement doesn’t seem all that probable as we continue to slog along at a now less than a 2 percent pace in GDP growth.

This combined with the volatility we have seen over the last few weeks caused by his earlier remarks bring to light just how sensitive the market is to the actions of central banks. I think everyone knows that by now but what may be less obvious to many is that this sensitivity is not isolated to the stock or bond market. It is important for investors to understand that the Fed’s tools are not scalpels: They are not precise; they are blunt. They are not smart bombs; they are weapons of mass destruction.

Artificially low interest rates raise the value of all assets. Last year I was meeting with a prospective client who was very hesitant to invest in stocks. Her reason was that the stock market was being pumped up with cheap money. So what was she investing in? Real estate. If there is an asset that has been artificially inflated by the Fed, it is real estate. To understand why that is, one must understand what it is about low interest rates that actually causes prices to rise.

The best illustration for this is a true story from my own life. In 1993 I was still renting an apartment in Atlanta where I had just moved the year before. I considered buying a house in an area of town called Peachtree Hills. The house I almost bought was listed for $150,000 and with mortgage rates near 8 percent my payment was going to be approximately $1,500 per month. I didn’t buy the house. Fast forward ten years and a friend of mine bought a house in that neighborhood – not the exact same house but a similar house. She paid more than $500,000. Her mortgage payment on her low rate Libor interest-only loan was a little less than – that’s right – $1,500 per month. The prices for houses in that neighborhood, like many desirable locations, had gone sky-high…or had they? The monthly payments actually being paid had not really changed. Low interest rates and creative mortgages made it possible to borrow a lot more money for the same payment and, let’s face it, most home buyers start and end with one question – what is the monthly payment? The housing bubble was inflated by low interest rates and consumers who bought homes based solely on what they thought they could afford on a monthly basis, which had not changed nearly as much as the supposed value of the homes they were buying.

Low interest rates inflate all assets, but especially assets that are purchased using debt. In other words: real estate. The brightest spot in our economy over the last several months has been real estate. Ben Bernanke mentioned tapering their quantitative easing program and mortgage rates have shot up a full percent. This makes one wonder: Is the real estate comeback for real or is it Fed induced? I don’t know the answer. I don’t think anyone knows the answer but we are likely to find out soon.

In the meantime I do know this: Fed policy may create short-term trading in the stock market and changing policy may create volatility, but stock values are ultimately tied to earnings. While some industries, like banking, have earnings tied closely to Fed policy, most do not. If interest rates do continue to rise, stocks will likely fare better in the long term than other assets.

Chuck Osborne, CFA
Managing Director

~He Said “If”

Ben Bernanke announced yesterday that the Federal Reserve (Fed) sees improvement in the economy and that if (and this is a big if) improvement continues, the Fed will begin tapering (not stopping and certainly not reversing) its bond-buying program known as quantitative easing or QE3. The reaction: stocks down more than a percent in the one-and-a-half hours of trading that occurred in our markets after his statement; bond yields up from 2.19 percent on the ten-year Treasury to 2.44 percent as I am currently writing; global markets down 2.5 percent; and finally our markets are about to open down another percent or so. Imagine what would have occurred if he hadn’t said “if.”

First let me state what should be obvious to our clients: Any time the market acts in such a way we are concerned and we will take what measures we believe to be prudent to protect our clients. Many of the recent moves we have made have been in anticipation of interest rates rising and should help. If that is all you wish to know then you certainly have my blessing to stop reading and go about your day. If on the other hand you are a bit more curious, please read further.

Two big questions hit me as Bernanke spoke. The first is, “What does the Fed know about the economy that we do not?” Their forecast was much brighter than it was just in March. Since their meeting in March GDP came in at a full percent lower than expectations, China’s economy has slowed dramatically. Just last week the IMF warned U.S. policy makers that we are at risk. Interest rates have risen dramatically, and one would think that could throw some cold water on the housing recovery, which has been the one bright spot in the entire global economic picture. How in the world does all of that equal a better outlook?

The second question is, “Does this market reaction make sense?” I often downplay the real impact of the Fed on long-term stock returns because ultimately it is about actual company earnings, and what impact does the Fed actually have on the earnings of any given company? The fascination with the Fed is overblown. However, the impact of Fed decisions is actually part of the CFA (Chartered Financial Analyst) curriculum. The real impact has to do with what Fed policy says about the economy, and more importantly to investors, what it says about the future of the economy. The textbook reaction to the Fed tightening monetary policy, usually by raising interest rates but in this case meaning they may buy fewer bonds, is supposed to depend on where we are in the economic cycle. If they raise rates during a boom because they are worried about the economy overheating, then the market should sell off as the Fed is trying to slow the economy which logically will lower company earnings. On the other hand if they raise rates (or in this case reduce QE) after having lowered rates in order to stimulate the economy out of a recession it is actually positive for stocks because this means that the Fed sees the economy getting better, and that should lead to better earnings. At least that is what the textbook says.

Of course, since 2008 nothing has really been textbook. The fear in the market is that the Fed, and in fairness other central banks around the world, has inflated asset prices and potentially caused another bubble after the two big bubbles last decade. It is possible that is true of some assets; gold and precious metals and bank stocks come to mind immediately. Everyone knows about gold, and the current earnings of big banks are almost all Fed-created as they are given money for free and loan it out at 3.5 to 4 percent. That will not last forever, though their shareholders seem to think it will. The rest of the market, however, does not look to be in a bubble. This concern seems overdone to us.

This leads to an important question: Why hasn’t all of this easy money, not just here but globally, led to actual economic growth? The answer can be found in “Abenomics” third arrow. For those who have not followed Japan, their Prime Minister Shinzo Abe has undertaken an aggressive economic policy – coined Abenomics – that consists of three arrows. The first two are aggressive fiscal stimulus and monetary stimulus, and these are the two that get all the attention. Spending and printing money is easy and popular for governments worldwide. The third arrow, however, is probably the long-term key to success: regulatory reform. It was a key ingredient to the Regan and Thatcher formula that stimulated global growth in the 1980’s and 1990’s and that made Bill Clinton declare the end of big government. It is the missing ingredient today. In Europe, for example, all the money printing in the world will not cause Spanish or Italian business owners to increase hiring, because they know that hiring an employee in their country is a relationship that is more legally binding than marriage and more expensive to dissolve. Starting a business today in the United States is more costly than in most of Europe. No amount of free money changes that fact. It has been the lack of the third arrow that has kept the global economy from recovering and made all the money printing largely for naught.

So, does the Fed really see improvement, or have they just come to the recognition that what they are doing isn’t working and they have to stop it sometime? Bernanke is out at the end of his term; Obama made that clear when he said that he had “stayed longer than he should have.” Regardless, Bernanke probably does not wish to leave the Fed before they at least begin some form of an exit strategy. The days of QE may be numbered even if that “if” Bernanke made in his statement doesn’t come to be. That may be what has the market going against the textbook response.

Chuck Osborne, CFA
Managing Director

~The Third Arrow

There were a lot of great songs written in the 1980s but, with all respect to any Animotion fans out there, this one probably wasn’t one of them. Like a lot of ‘80s music it will stay with you, and to anyone who finds themselves accidentally singing “Obsession” on your way home tonight I certainly apologize. There is just no better way to describe the market’s fascination with central bank activity. Markets have always paid attention to central bankers but recently they seem to be truly obsessed, and it is not just with our Federal Reserve (Fed) but with any central bank – Europe, Japan, etc. The market has become hypersensitive to them all.

This seems somewhat strange to me because this obsession comes at a time when central bank power should really be questioned. After all, if what they do has so much control over the economy, then why isn’t the world experiencing the greatest economic rally of all time? It brings to mind another ‘80s classic which could be paraphrased like so, “This economy is so sluggish, there’s no tellin’ where the money went.”

We have never thought that so-called quantitative easing was the great evil that many pundits seem to think, but we also never thought it would work, and thus far we have been correct on both accounts. There is no evidence that real harm has been done. There are plenty of reasonable theories that suggest harm may be coming, but thus far the fact is that inflation has not spiked, the dollar has not become worthless, the earth has not stopped spinning, and we are not floating to our doom in outer space. Of course this realization will not keep eyes glued to a TV screen, so you are not likely to hear it from the financial pundits. However, this combination – no obvious harm and no success – is likely to encourage more of the same. The talk of the Fed pulling back is overblown in our opinion.

Of course today everyone is concerned about what happens when the Fed reverses course. The real fear mongers will put it like this, “What do you think will happen when the Fed has to sell all of those bonds they have been buying?” In fact in writing this article I googled quantitative easing and the first article that pulled up was from Time. The author, Paddy Hirsch, tells us that the Fed has purchased more than $2 trillion in Treasury bonds (this article is a year old so the number is much higher now), and he goes on to state, “At some point in the future it [the Fed] will have to sell all the bonds in bought.” Paddy and all the fear mongers go on to explain that when the Fed sells all of these bonds, interest rates will shoot to the sky, the cost of everything will skyrocket and our economy as we know it will cease to exist. It is all really scary and gripping stuff that probably sells a lot of magazines. Unfortunately it is built on a fallacy: The Fed does not, nor will it ever, “have” to sell a single bond.

When we give financial education sessions we always begin by saying that all investments can really be put in one of three categories: stocks, bonds or cash. Stocks are simply ownership in a business, and bonds are simply loans. Much of the time we can see the “sophisticated” audience members tuning out. Their expression usually says, “This is too simplified for me but it is great for my colleagues to hear.” The truth is that we all need to hear that message over and over again. On Tuesday of this week I gave a speech at a conference for advisers to the so-called ultra-high-net-worth marketplace. I was asked at least three questions from this very sophisticated audience, which suggested that the participants had forgotten what stocks and/or bonds really are. On Wednesday evening I was at an event for the CFA Society of Atlanta. Every single person in that room holds the most coveted credential in the financial world and in some form or fashion analyzes and/or manages various types of investment portfolios. There simply isn’t a more sophisticated investment audience, and multiple times I found myself in conversations where this simple truth seemed to be forgotten.

Bonds are loans and loans are paid back, or as we say in the financial world, they mature. The Fed, or any bond investor for that matter, can simply hold on to the bonds they own and eventually they will all mature and be no longer. Bondholders don’t ever have to sell. This doesn’t mean that the Fed may not decide to sell some of the bonds it has accumulated, but the idea that the purchasing must go in reverse is just plain wrong. Today the Fed is talking about easing off of the quantitative easing. In other words, they are talking (not doing, mind you, just talking) about buying slightly fewer bonds per month. Hardly Armageddon.

Stocks are ownership in a business. How will the Fed’s slow down (if they actually do it) of bond purchases impact stocks? It depends on the business. How will it impact your business? For most of us the answer is probably not at all. This does not mean that short-term traders won’t use it as an excuse, but these daily market gyrations only provide opportunities for those who are wise enough to remember what stocks and bonds really are and that investing in them is best done with a long-term mentality.

In the meantime, we are likely to hear more about this strange obsession. If you are a trader or a pundit the end-of-the-world story is, in the words of Robert Palmer, simply irresistible. That doesn’t make it true.

Chuck Osborne, CFA
Managing Director

~“You Are An Obsession, You’re My Obsession…”

Late last week I was talking to a client who mentioned it had been a while since we last sent out an Insight. I explained, as I often do, that we only write when we feel there is actually something worth writing. Of course the very next morning we come in the office and Japan’s market is down more than 7 percent. That is a big drop in one day and speaks to the issue we discussed in our last Insight: This market is increasingly fragile.

Some background may be necessary here for our clients that do not follow the markets as closely as we do. The market in Japan has been on a tear, up more than 40 percent year-to-date in local currency (that gain has been almost halved by the drop in the yen for non-Japanese investors). All of that return is based on the extremely aggressive measures taken by the Japanese government to kick its economy out of the deflationary spiral it has been in for more than twenty years. They have undertaken a policy of fiscal and monetary stimulus of proportions that are somewhat mind-boggling. Interest rates in Japan have been at or near zero for as long as I can remember, and they have tried many rounds of quantitative easing which has been as ineffective there as it has been here in the United States. But now they are purchasing their own debt at a rate that is just barely slower than what our Federal Reserve is doing at home. However, Japan’s economy is approximately one third as large as the U.S., so in relative terms they are printing yen at three times the pace we are printing dollars.

Thus far all this activity has done little other than slightly help exports (a weak yen makes Japanese products cheaper for non-Japanese) and create a potential bubble in their stock market. To paraphrase Winston Churchill, trying to promote lasting economic growth through fiscal and monetary stimulus is like trying to stand in a bucket and lift oneself up into the air with the handle. It does not work, because any money borrowed today must be paid back tomorrow and while they can have short bursts of growth, ultimately they are digging a larger and larger hole. Japan is living proof of this. They have accumulated more debt relative to their GDP than any other nation on earth by trying to stimulate themselves out of their deflationary spiral for more than twenty years. Instead of learning their lesson they have decided that all the other attempts were just too small. They will do not just more of the same, but a boat-load more of the same, and hope for a different outcome.

But, thankfully it is not our job to fix Japan; it is our job to manage money. Whenever stock market values rise for reasons other than the fundamental improvement of the companies whose stocks are represented in the market, it is illusory and will end badly. Japan’s market was bound to have a day like Thursday, and there will probably be more. Prudent investors do not get caught up in such folly. Knowing what you own and why you own it is critical, and there had better be some real intrinsic value backing your investments or one day they will simply go “poof.” Bubbles always burst, and chasing them believing one can know when to get out is very risky. The relationship between risk and return is one of the most misunderstood and over-simplified relationships in all of investing. More risk does not guarantee more return; it only guarantees more risk. Some investors learned that in a very sudden and painful way on Thursday. Thankfully for you, we already knew that at Iron Capital.

On a personal note, I hope all of our friends and clients had a happy and safe Memorial Day weekend. Our thoughts and prayers remain with our friends in Oklahoma, and we urge everyone to remember those impacted by the storm in the days and months ahead. For those looking for ways to give we would suggest two organizations for consideration. One is the Alvis Foundation, which is a private family foundation located in Norman, Ok., now accepting public donations to assist in grassroots efforts following natural disasters and unanticipated events resulting in severe hardship. They have committed to sending 100 percent of any donations directly to victims of this storm. The other is UMCOR (United Methodist Committee on Relief). UMCOR is a larger organization run by the United Methodist Church whose full administrative cost are funded by the church, allowing 100 percent of any money received to go to victims of natural disasters. Of course there are many other worthy ways to give, including larger organizations like the American Red Cross and the Salvation Army.

Warm Regards,
Chuck Osborne, CFA
Managing Director

~Pop Goes The Bubble?

For years I have been giving the same talk about the standard measures of risk used in the modern financial world: standard deviation and beta. Standard deviation is a measure of absolute volatility, while beta is a measure of relative volatility. Standard deviation measures the average, or “standard,” difference, or “deviation” (we financial types are really creative with our terminology) between actual returns and the long-term average returns. Beta is the difference between an investment’s return and the market return over time. For those eighth grade geometry students out there, beta is the slope of the line representing the relationship between a particular investment and the market as a whole. After explaining this I make sure everyone is awake by telling the same joke I have told for more than 20 years now: The problem with standard deviation and beta is that they measure volatility, and volatility goes in both directions. No client has ever complained about upside volatility.

It is funny, relatively speaking, because it is true. Last week the market, as defined by the S&P 500 index, was down more than 2 percent; they call that volatility. That downward move has been almost erased in two days; they call that a rally. The truth is that both moves are examples of increased volatility, and both understate what is occurring underneath the surface. The intra-day moves on some stocks have just gone nuts recently. Mining company Cliff Natural Resources has seen four percent swings on two of the last three trading days, and Apple dropped almost five percent on rumors last week. Holly Frontier, the oil refiner, has had a full correction – down ten percent and then a full recovery in a matter of four or five business days.

What does all of this mean? It means this market is becoming more fragile. It is as if everyone knows that there must be a correction looming, so any bad news sends individual companies down quickly. But everyone also knows that stocks seem to be the most attractive place for the long term, so any correction is likely to be followed by a rally, and no one wants to miss the rally.

In the meantime, while the market is hyperactive, nothing has really changed in the real world. We are back to the same old broken record: The economy is slugging along at a two percent pace and the economic forecasts continue to swing wildly around that seeming constant. Recently we swing from over-confidence in forecasts, with some economists recently projecting as much as three and a half percent growth, and right back to reality. Soon maybe we will be getting the warnings of another recession. Meanwhile the economy itself just slowly chugs along, ignoring all the wild predictions.

While I was writing this the market dropped one percent and immediately rebounded on a rumor from a false tweet about an attack on the White House. Is volatility back? It appears to be, and that is not all bad. Long-term investors can often take advantage of the hyper over-reactions of the market. Should a correction finally take hold that is what we would recommend.

Chuck Osborne, CFA
Managing Director

~Is Volatility Back?