It is always hard to tell what will actually trigger a correction. This week it seems like Cyprus is the culprit. The story out of Cyprus is almost surreal; the thought that the government could just come in and take ten percent or more of your savings is bizarre to our ears. In an almost comical twist, these events have Vladimir Putin pontificating on the importance of individual property rights.

In truth the story is more complicated than it seems. The so-called tax is really an attempt to have depositors, many of whom in this case are frankly unsavory characters involved in laundering money gained by ill-gotten means, to share in the cost of saving the banks. If these banks are not saved, depositors stand a likely chance of losing most, if not all, of their savings. Of course the tragedy in this case is the perfectly innocent smaller depositors, and sympathy for them is what has caused the political crisis.

However, one must ask if Cyprus is really meaningful enough to warrant such a market reaction. My guess is that this mini-crisis is more of an excuse than a reason for markets reversing course this week. I would argue that the correction had already begun when Cyprus hit the news.

Individual investors have a very harmful habit of looking only at the most publicized market indices, usually the Dow Jones because the Dow’s ups and downs are reported every day among mass media. Looking only at the total results from a broad index and not what is happening underneath the surface can be very misleading. The index could be up even when the majority of stocks in it are down, or vice versa. This happens when only a few sectors or perhaps even a handful of darling companies are doing fantastically while the rest of the world does nothing or even loses ground. Paying attention to what is happening under the surface is really more important in the long run, as these dislocations have a way of fixing themselves over time.

In this latest rally, for example, the stocks of technology companies have largely been left behind. On the other hand one of the hottest areas of the market has been oil refineries and drilling companies that are benefitting from North America’s energy boom. Over the last ten days or so we have begun to see these energy companies come off their highs, with a few already hitting the ten percent drop in price that is defined as a correction. In the meantime there appear to be some signs of life on the technology front. This type of rotation is often an early sign that the correction is happening. The broader markets may not drop the usual ten percent before regaining upward momentum. While many commentators try to sound authoritative, the truth is no one knows exactly what the market will do in the short run.

In the long run equities remain the most attractive asset class, and that will remain true as long as interest rates stay this low. Any correction – whether in the broad market or just underneath the surface – should be used as an opportunity to rebalance, which is exactly what we will do.

Chuck Osborne, CFA
Managing Director

~Has The Correction Begun?

2013 has gotten off to a wonderful start for equity investors. After what must be one of the luckiest years on record in 2012, the S&P 500 continued the ride up more than 7 percent year to-date, and then the Fed had to go and ruin the party. The minutes of the last meeting of the Federal Reserve’s Open Market Committee came out Wednesday, and shockingly to some traders it showed that a few of the committee members are concerned with the long-term ramifications of the Fed continuing to purchase bonds in their effort to keep interest rates low. Of course in typical overreaction style some pundits are saying this means all of the Fed’s “easing” will soon come to an end.

It should be seen as a positive that at least some at the Fed are concerned with the possible ramifications of these unprecedented actions. I want to make it clear that we are not among the fear mongers who think this money printing binge will destroy civilization as we know it. My family does not have, nor do we plan on building, a shelter with years’ worth of nonperishable food and tanks of clean water, let alone an arsenal to protect us when government collapses. However, just because the Fed is not causing the end of the world does not mean that its activities are completely benign. The Fed, in its attempt to keep us from falling into a deflationary spiral, has pulled out all of the stops and is in uncharted waters. As I have said before, Bernanke is a student of the Great Depression and is absolutely determined not to make the same mistakes that our central bank made during that crisis. As a result he is making all new mistakes. It should be much more concerning to market participants if no one at the Fed were concerned.

The mere fact that some of the committee members express thoughtful concern does not in and of itself mean that the Fed will slow the presses any time soon. After all, they expressed concern right before voting to stay the course. The Fed will not slow down its activity until there are actual signs of sustained improvement in the economy or real signs that its policies are beginning to cause harm. Neither of those cases can be made in any convincing manner at this time, so one should expect that the Fed will stay the course for the foreseeable future.

What the Fed minutes really did was provide an excuse. Traders have been itching to take profits and cause a pullback. It is healthy for the market to pull back every once in a while, and it had been on a long run beginning late in the year last year through the first six weeks of 2013. This may be the beginning of the pullback or the pullback may come later, but it will come. We expect at worst a 10 percent correction, and then the market should continue its upward climb into new highs. Remember every time the news talks about record highs all that means is that the market is back to where it was in 2007, which is when it finally got back to where it had been in 2000 – but that is an entirely different Insight.

Chuck Osborne, CFA
Managing Director

~All Eyes on the Fed

The fourth quarter 2012 Gross Domestic Product (GDP) number came in earlier this week and it was surprisingly negative, -0.1 percent to be exact. Jim Cramer, the colorful CNBC personality, immediately called it a “one-off.” In other words it is just a statistical anomaly to be ignored, and the market has pretty much acted accordingly. But is he right? Should we just ignore negative growth? After all, if we have negative growth again this quarter, that would mean we are officially in a recession…right?

Well, Cramer is only half right (which, for him, is actually pretty good). What the fourth quarter really was is a return to the mean. The actual statistical anomaly was the third quarter 2012 GDP, which on the surface appeared to be a robust 3.1 percent growth, but was actually caused by an explosion in government spending. Likewise the negative growth in the fourth quarter was caused by a sudden stop in that spending. What we are really witnessing is the effect of the fiscal cliff and the spending element of that deal, which Washington has named “the sequester.”

As we have written previously, if a good bureaucrat knows her budget will be slashed next year she will do all in her power to spend every dime she has this year. It is no coincidence that the government’s fiscal year ends on September 30. Faced with uncertainty at best and large cuts to one’s budget at worst, the bureaucrat is going to spend, and so they did. However, all this does is move consumption that would have occurred under the normal course of business in the fourth calendar quarter into the third calendar quarter. So in actuality a large portion of the government’s fourth-quarter spending was simply accelerated into the third quarter, making third quarter GDP look great and the fourth quarter look recessionary. I believe the truth is found by averaging the two. The 3.1 percent growth and the 0.1 percent contraction equal 1.5 percent GDP growth per quarter for the second half of 2013. This is in line with the 1.3 percent growth in the second quarter and with our new normal of slow growth.

The good news is that there are signs that some areas of the economy are picking up, especially in housing. We expect about 2 percent growth in 2013, which isn’t great but it is better than the last three quarters of 2012, and any improvement should be welcomed. Many of the crises that haunted us last year seem to have passed, and with bond yields still below 2 percent, there really is nowhere for investors to go but stocks. This should help the market.

Of course with growth as slow as it is likely to be, it will not take much to push us into recession. We stand ready to act, but for now I think the full second half of last year was one statistical anomaly.

Chuck Osborne, CFA
Managing Director

~Recession or Statistical Anomaly?

So we went over the cliff after all, but only for a day. There is much to dislike about the deal that avoided the worst-case scenario for across-the-board tax increases; what one decides to dislike will depend on politics, but regardless the deal was a compromise and these days that means no one will be happy with it. What is perhaps lost in this year-end excitement is that this was one last in a long line of crises averted in 2012.

I am not the superstitious type – of course it is bad luck to admit to being superstitious, so I would say that regardless – but as I understand it, 13 is an unlucky number. Now we are going to have a whole year of 2013. I am not sure what to make of that except it seems unlikely that we could have as much luck as we did in 2012.

A year ago the outlook globally was bleak. In January 2012 there was probably a better than 50 percent chance that the Euro would not survive the year. There is still much wrong with Europe, but intervention from the European Central Bank has averted the worst-case scenario there.

A war between Israel and Iran was predicted before the end of last spring. The Middle East is hardly a model for world peace, but no bombs flew between these two in 2012.

China’s economy was slowing and a hard landing was feared for the second largest economy in the world. However by year-end, signs of life have begun to show in the Chinese economy.

We faced an election at home and a fiscal crisis of our own. This last minute deal to avert the worst of the tax increases still punted spending cuts and the debt ceiling down the road, but those are now 2013’s problems.

Of course no 2012 crisis aversion discussion should be had without bringing up that, according to the Mayans, the world was supposed to end on December 21, and here we are. This may have been the largest crisis averted of all.

Will 2013 be as lucky? No one knows for certain, but there is reason for cautious optimism. Economic indicators have been improving at the margins, and many of the fears from a year ago have been diminished. This is not to say that we are completely out of the woods, but are we ever? Any of the scenarios that didn’t happen in 2012 could very well take place in 2013; after all Europe is still a mess, Iran and Israel still don’t like one another, and we still have debt ceiling and spending cut battles in our future. There is no doubt that we must stay vigilant, but it is the beginning of a brand new year. What better time to see the glass as half full?

Happy New Year to everyone, and may 2013 be our luckiest year yet.

Chuck Osborne, CFA
Managing Director

~Lucky ’13?

Instead of boring everyone with more discussion about the fiscal cliff, I thought I would take an opportunity to provide some insight into how investment professionals actually find investment opportunities and the difference between investing and speculating. Apple provides us with that wonderful opportunity.

Apple is one of, if not the most, successful companies in the world. Over the last five years they have grown earnings at a rate of 62.2 percent per year, and that is during the “Great Recession.” Imagine what they could have done in a good economy. They have the hottest smart phone on the market, the number one tablet computer and on and on.

There is a cliché on Wall Street that says great companies make lousy stocks. The reason for that is because most great companies have all their greatness priced into their stock. Usually great companies sell at large premiums to the market in terms of their price-to-earnings ratio. For example in 2004 when it was clear that eBay would be a successful survivor of the tech bubble, they sold at a price that was in excess of 100 times their current earnings. eBay has done well as a company, much as expected, and their stock is currently selling at around $50 per share, a full $7 per share less than their 2004 peak. Great company, lousy stock.

Many people assume the same is true for Apple, but they simply are not looking at the reality. Apple is currently selling for 12 times its earnings. To put that in perspective, the S&P 500 sells at almost 17 times its earnings. In other words the price for an average company today is 17 times earnings, but one of the greatest companies on the planet sells for considerably less? How could that be?

Part of the answer is in investor psychology. While Apple’s stock is cheap by just about any measure, it looks expensive because Apple has not split their stock. Apple hit its peak of a little over $700 per share earlier this year and a lot of smaller investors get nervous about that large of a price tag, after all what stock is worth $700? This is a classic case of perception trumping reality. The share price is a mere accounting function, determined by how many shares the company wishes to have outstanding. Apple could have split the shares 10 for 1 and every shareholder who held one share at $700 would now hold ten at $70. The reality is the same – the same percentage ownership of the company, the same total value. However, had Apple split its stock and the price tag appeared to be $70 vs. $700 I would wager that the stock would have jumped significantly. After all a company like Apple should be trading at a large premium to the market, not its current discount.

As it was the stock peaked at $705 and has been in a downturn ever since. This started most likely because of simple profit-taking; Apple’s stock sold for as low as $380 per share just a year ago, so some investors were sitting on hefty gains. No doubt this activity was exaggerated by the threat of higher taxes on investment gains next year. Then the “technical analyst” started talking about how awful Apple’s chart looks and the fall continued. For those who are not familiar, technical analysis sounds very sophisticated but it is nothing but the tracking of prices to attempt to find patterns which indicate the future direction of prices. Academics hold technical analysis in approximately the same level of regard with which they hold witch doctory. It has a dubious record as there are no actual investors who credit long records of success to its practice, but it does one thing well: it turns investors into speculators, making otherwise rational people buy and sell stocks like riverboat gamblers. That is good for business, which is why almost all technical analysts work for Wall Street firms. There is no such thing as a buy-side technical analyst.

The technical witch doctors are assisted in scaring people by Apple’s stock price. The drop from a $700 price to a $500 price is much more compelling on CNBC than a stock that dropped from $70 to $50. Of course in reality those are the same thing and the stock that dropped from that level can get back there just as quickly, but the perception of investor fear is far greater with higher numbers.

In the meantime, as Apple’s stock price drops the company itself is doing fantastically. Just this past weekend they announced selling two million iPhone 5s in China on the day of its launch; the most optimistic analyst we saw thought they would sell four million in the first quarter and they did half that the first day. They still have lines around the world for their products and they have a brand loyalty that is second to none.

Speculating is guessing which way a stock’s price will go next week and I would guess that technical analysis is as good at doing that as any other similar method – the magic 8 ball, darts, dice, etc. Investing, on the other hand, is about buying things of value at a good price and waiting patiently for the value to be recognized. Benjamin Graham defined investing as follows, “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return.” That safety of principal was found in what he called the margin of safety, which is the difference between an investment’s actual value and the price. We calculate Apple’s actual value at more than $1,000 per share, assuming 18 percent growth over the next few years, down from the 62percent growth they have had over the last five years. Don’t just take our word for it; many sell-side analysts have price targets ranging from $800 to $900 per share. That is a huge margin of safety.

Of course we could be wrong; there is always risk in investing. Apple may suffer a complete collapse like other companies of the past, but if that possibility – however remote – did not exist, then the opportunity would not exist. The thing about margin of safety is that it is at its highest precisely when the perception is the opposite, otherwise the price would not be so low and the margin would not exist.

Owning Apple directly is not appropriate for everyone. We do own it in many clients’ portfolios and it is a large holding of several mutual funds, so most of our retirement clients have indirect ownership. That is not the point here. The point is to start to learn what an investment opportunity looks like when it happens. Apple is it.

Chuck Osborne, CFA
Managing Director

~Investing, Speculating, and Apple