I remember the late winter storm in 1994 that hit the entire East Coast from Florida to Maine. It dumped more snow on Atlanta than we have seen since and was deemed the “Storm of The Century.” In the next six years I believe there were three or four more “storms of the century” or other similarly exaggerated names. Let’s face it, our popular culture has a narcissistic streak to it. Our storms are bigger, our athletes more dominant and our political crises are more critical.

If only any of that were true. Today we are surrounded with talk about this “unprecedented political standoff.” It has been said that it would be unprecedented for the debt ceiling increase to be used as political leverage, even though that is exactly what has happened since the 1970’s with even our own President voting against an increase when he was in the Senate. I have read that it is unprecedented for one party to shut down the government when they only control one house of Congress. The list goes on and on.

The old saying goes that one can pick one’s point of view, but one cannot pick his own facts. Standard and Poor’s (S&P) sent us some interesting data on government shutdowns last week that I think is worth sharing: Since 1976 the government has been shut down 18 times; several times for just one day, but the longest was for 21 days during the Clinton administration. Seven times, all during the Reagan administration, the government was shut down when the opposition party controlled only the House of Representatives, as is the case today. Interestingly the government was shut down five times during the single four-year term of the Carter administration when one party controlled all of Washington. Not only was it shut down under one-party control, but the shutdowns lasted longer. Carter owns the second longest shutdown of 18 days, the third longest at 12 days and the fourth longest at 11 days. The S&P data went back to only 1976, but I would assume the longest absence of our federal government, as we now know it, would be the eight years between the final victory at Yorktown in 1781 and the final ratification of the Constitution in 1789. Those were political disagreements of an actual historic nature. To my knowledge no one has yet threatened a duel on the Common as a possible solution to our current stalemate.

Why has the market largely ignored this Washington side show? I like to think it is because a lot of us understand that there is nothing historical or even unique about the current level of political tension. Whether the shutdown continues or not, the probability of a debt ceiling extension not happening seems slim. So, not much has really changed.

In other news and random thoughts, the Nobel Prize in economics was split between three U.S. economists: Eugene Fama, Lars Peter Hansen and Robert Shiller. Fama is famous for espousing the so-called efficient market hypothesis, which is the backbone of Modern Portfolio Theory. Hanson works with Fama. Shiller, using some of Hansen’s work, is famous for proving Fama wrong. This has nothing to do with your portfolio, but it is good news for us because it shows that not even the Nobel Prize committee understands what economists are saying. Now that is what I call job security.

Chuck Osborne, CFA
Managing Director

~We Are Never The First

Sometimes we forget how much wisdom there is in the classic children’s stories. Consider Aesop’s Fable “The Boy Who Cried Wolf.” The first time he cries wolf everyone comes running, worried about the wolf attacking the sheep. The second time much the same and so on, until people finally get tired of all the false alarms. When the wolf actually comes, no one believes it.

We are having a governing crisis! Yep, it works in real life too. The government has shut down and we, like the villagers in Aesop’s fable, seem to be letting out a collective, “whatever.” To be clear, the government is not actually shutting down. Services deemed essential will remain in operation. That means the vast majority of us will not notice; which leads one to wonder why the government has “non-essential” departments in the first place?

While that is an interesting question our concern here is investing not politics, so the more important question is: What impact, if any, will this shutdown have on your portfolio? Most likely the impact will be in line with that of the Bush tax cut expiration, the sequester, the Cyprus banking crisis, etc. I think we have all had our fill of the government-created crisis. It just doesn’t scare us anymore.

In the meantime, the world outside of the Washington beltway is looking pretty stable. The economy continues to just slug along, which isn’t great but isn’t horrible either. Valuations on the equity market as a whole are reasonable, and international markets are becoming more attractive. Interest rates seemed to have peaked at 3 percent on the ten-year Treasury and are now slowly and quietly working their way back down towards 2.5 percent, maybe even lower. All of that bodes well for equity investors.

So, it is pretty quiet out here in the real world, which brings us back to our fable. Eventually the wolf actually did attack the sheep, and that is the real danger we face today. Having become numb to the drummed-up crisis of the day, will we actually underestimate a real crisis when it comes? That keeps us ever mindful that these political games, as painful as they are to watch, cannot be ignored. So we at Iron Capital will continue to watch and guard against the numbness.

Chuck Osborne, CFA
Managing Director

~Crying Wolf

The stock market has been down four whole days in a row and media is all abuzz. Interest rates are on the rise as market participants continue to worry about the Fed’s tapering off of quantitative easing. The rate on the ten-year Treasury has now gone from 1.5 percent to 2.8 percent. That is a big rise, and of course as rates rise, the value falls. This brings us to the concept of risk in investing and how it can be managed.

The first step in managing risk is defining it. There are four primary definitions in the financial world and which one you use will have a big influence in how you manage your investments. I will call the first definition the legal claim definition. Different investment vehicles provide different claims on assets. Bonds, for example, are simply loans, and loans are generally backed by some form of collateral. The bondholders of a corporation have a claim on the company’s assets should the company fail and go into bankruptcy. Stock is ownership in a company and should a company fail, the owners will get only what is left after all the bondholders’ claims have been settled. In this view bonds are always safer than stocks.

The problem with this definition is that legal rights do not trump the laws of physics. It reminds me of a former colleague, an attorney who served as in-house counsel at Invesco. He and I would often go to lunch together and in doing so we would have to cross a few streets. He had a habit of walking right out in front of oncoming traffic. I would tell him not to do it and he would respond, “I’m in the crosswalk and have the right of way.” I would often tease that I would be sure to tell everyone that when I was speaking at his funeral. The legal rights to assets mean little if there are no assets to be had, and perhaps less obviously they also mean little if there are more than enough assets to cover all claims and leave the owners with a windfall. This is a poor definition of risk in the real world, even though it dominates popular investor education materials.

The second definition is that risk equals volatility. This is the dominant view of the investment world. Risk is defined as standard deviation and/or Beta, both mathematical terms which measure respectively the absolute and relative price movement of financial assets. Under most circumstances stock prices move more than bond prices, so this view also leads to the conclusion that bonds are always safer than stocks. The problem here though is that volatility goes in both directions. Do we care equally about upside volatility and downside volatility? Most investors I know do not. This leads to the phenomenon of investors saying that they want to take on more risk when the market is going up, then less when it starts going down. I would argue that any useful definition of risk would not change with the direction of the market.

The third definition is relatively new and it is exclusively used within the investment world. This is the risk known as tracking error. It is the measure by which a fund manager’s return differs from the market benchmark by which he is judged. This measure is completely useless to the client as what it really measures is career risk for the professional. The idea is that as long as one looks like the benchmark, the client won’t fire them. It is one of the most damaging results of relative return-focused investing.
Finally there is what we believe to be the real definition of risk. Risk is the probability of losing money (or not making enough) over a given investment horizon. In this definition there are no absolute relationships because the safety of an asset is not primarily determined by legal structure or price volatility and it certainly has nothing to do with the relationship between it and some arbitrary definition of “the market.” The risk of losing money is determined by the price an investor pays. If one pays more than what an asset is worth, then that investor is likely to lose money. If one pays less, then that investor is likely to do well. By this definition bonds can be riskier than stocks.

Third quarter to-date through this past Friday the S&P 500 is up 3.4 percent and the Barclays Aggregate Bond index is down -0.90 percent. Which looks more attractive to you? When bond yields are as low as 1.5 percent for a ten-year obligation then the risk of owning them is high, if you consider risk losing money or at best not making enough. With rates at that level the best case scenario is that one gets the 1.5 percent gain. That won’t pay for much of a retirement.

We have been saying this in our forecasts for some time, and of course earlier this year we moved to an under-weight to bonds and diversified our bond exposure to try to mitigate the risk of rising rates. We didn’t do that because we are clairvoyant; we did it because we understand that risk is price. When bonds are that expensive, it is best to sell them and own something more reasonably valued; in this case, stocks.

Seth Klarman, the famous hedge fund manager, is fond of saying that Wall Street has the habit of taking the safe label and putting it on risky assets and taking the risky label and putting it on safe assets. This is because too many have the overly simplistic view that risk is somehow predetermined by legal structure or volatility. Prudent investors understand that risk is price. Any asset can be safe if the price is right, and likewise any asset can be risky if the price is wrong. Recognizing the difference is the essence of prudent investing.

Warm Regards,
Chuck Osborne, CFA
Managing Director

~What Is Risk?

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