Happily we go straight to the cliff. Will we go over it? If so, will we go way over, or will we just dip into January to get that dropping sensation in our stomachs before pulling the parachute cord?

The fiscal cliff is all anyone talks about these days. The market seems confident that a deal will be done. I’m not sure why, as nothing that has been shared in public has been very reassuring. One theory is that politicians are actually not in a hurry because the market has not signaled desperation. That leads to some interesting circular reasoning: the markets stay relatively calm, putting faith in politicians who end up doing nothing because they have faith that the market would signal a real need to act.

Perhaps even more puzzling is the fact that consumer sentiment is at a five-year high. I saw a projection from one economist who believes unemployment will go to 11 percent if we go over the cliff, and of course as we wrote last time, the first effect of the cliff will be increased taxes out of consumers’ January paychecks. Consumers also seem to be going all-in on our government coming to a solution, and I fear their faith will be one more excuse for our politicians to delay. If the consumers aren’t worrying, then why should politicians?

It certainly is a curious time. The market did begin to act as we thought it should immediately after the election, then it decided to go up nearly 4 percent over Thanksgiving. Usually moves like that are ignored by investors because it was on anemic volume over a holiday week, and one assumes the professionals will be back at work the next week and will correct that false optimism. Thus far that has not happened.

Most of the talking heads have been saying that they believe the market will pop big when a deal is announced in Washington. We think that is probably true, but what happens if a deal is not forthcoming? It appears that option is not even being considered. We think this phenomenon presents one of those binary moments when only one of two things is going to happen: a deal will get done and the market will go up dramatically, or a deal won’t get done and the market will drop dramatically. We prefer to err on the safe side of that bet.

Either way we will get beyond the cliff and when we do, there are beginning to be some bright spots. Housing is truly improving and the economy grew faster than originally believed in the third quarter. Economic weakness in Europe has had one silver lining in that reduced demand for commodities has eased the pain at the pump for many consumers. Earnings growth in the third quarter has settled to -0.9 percent, according to FactSet, which ends an eleven-quarter streak for positive growth, but this is better than the almost 3 percent drop that was expected. Revenues, on the other hand, did disappoint with 59 percent of companies missing estimates, so don’t get too excited just yet. Still it feels like it has been a long time since there has been anything positive to talk about so I am seizing the moment.

The bottom line is that all eyes are on Washington until we either go over the cliff or come to an agreement. It is time to be nimble and hope Santa brings us something good for Christmas and not a lump of coal.

One final note. Our political class is, by and large, more opportunistic than idealistic. Of course there are exceptions, but for most politicians the unwillingness to compromise comes not from core values but from the knowledge that doing so will be used against them when they run for re-election. If you really want our leaders to work together, which requires compromise on both sides, then you might consider letting your elected officials know that by shooting them an email or phone call. If you do so and they follow that lead, then we should do everything in our power to make sure that they don’t get punished for it in the next election. Food for thought.

Chuck Osborne, CFA
Managing Director

~Someone Must Know Something I Don’t

Are we headed over the “fiscal cliff” or will our politicians come to an agreement? Your guess is as good as ours, but as there is at least some chance we could go over the cliff, we should spend some time understanding what that would actually mean.

The first impact that most of us will feel from the fall is the loss of the so-called “payroll tax holiday.” For those who don’t follow every tax we pay very closely, the payroll tax is probably better known to you as FICA, or your Social Security and Medicare contributions. For the past few years we have been contributing 2 percent less than we are supposed to into these entitlement programs. Abby Phillips, in an article for ABC News online, says this will mean on average an extra $672 in taxes for people making between $40,000 and $65,000 per year. For higher wage earners it will mean on average an extra $1,135 in taxes.

The second blow comes from income tax hikes, which will impact tax withholdings with the first paycheck of the New Year. Of course it has been well-publicized that the top rate will go from the current 35 percent to 39.6 percent, but in addition, just about everyone will see about a 3 percent increase. Phillips estimates that the average earner in the country making between $40,000 and $65,000 will see an increase of $888 in income taxes. Add that to the payroll tax increase and you are talking about an increase of $1,560.00 for the average American, which will begin to hit paychecks in January.

After these initial blows we will see the impact of the taxing of investments. Dividends will be taxed at ordinary income instead of the current 15 percent rate. Remember dividends are corporate income that has already been taxed at the corporate rate, so this additional tax is icing on the cake for Uncle Sam. This means that for every corporate dollar earned and paid as dividends, the shareholder in the top tax bracket will receive approximately $0.39. Add to that the new health care tax and it drops even further.

Long-term capital gains tax will go up as well, from 15 percent to 20 percent plus the 3.8 percent health care tax. This is one that makes little sense. Capital gains represent voluntary income; one must sell an asset in order to realize a capital gain. If people believe the rate is too high they simply refuse to sell. Warren Buffett assures us that this is not the case, but he is mistaken. Warren will not change his investing behavior, nor will any of his professional investing friends. We will not change either, but that is because rational investors are not going to allow the tail to wag the dog. I have written newsletters on this subject, and for good reason: most retail investors are not rational, and a known tax hit is too hard for them to stomach regardless of how much better other investment options may appear. Others are actually being rational because the capital gain would not only create a tax hit on their investment return, but actually would put them in a higher tax bracket, or worse yet, subject them to the Alternative Minimum Tax (AMT).

In addition to the tax hikes government spending will be cut, especially spending on national defense. The sum of it all points to lower spending by consumers due to lower take-home pay, coupled by less effective distribution of capital as investors will be less willing to realize gains for tax reasons. This will hurt retailers and small businesses the worst, followed by companies with government contracts. In other words: recession here we come.

This all could be at least partially avoided with political compromise, and there have been some positive signals from Congress in that regard. However, until an actual deal is crafted, the cliff remains a possibility. Our best guess is that a stop-gap solution is found followed by more comprehensive tax reform in 2013. That would be much better and at least alleviate the immediate hit on consumers, but it still creates a difficult environment for business leaders to make future plans. Economic activity is likely to be slow in the beginning of 2013 even in the best case scenario.

This brings us to our national holiday. These are difficult times but we still have much for which to be thankful. As is our tradition here is my list.

1. I am thankful that the United States of America is, with all of our issues, still the best place to live and invest within the developed world.

2. I am thankful that I can still run a half marathon even if it does take a little longer than it did when I was in my twenties.

3. I am thankful for my family, immediate and extended.

4. Of course I am still grateful for Mama’s pumpkin cheesecake and my loose-fitting pants that make the enjoyment of said cheesecake possible.

5. Last but certainly not least, I am thankful for you, our clients and friends of the firm. Your trust in Iron Capital is our greatest asset and we value you every day of the year.

Happy Thanksgiving!

Chuck Osborne, CFA
Managing Director

~Over The Cliff?

My guess is that there is only one positive outcome all Americans can agree on as a result of last night’s election: no more political ads…until the next time anyway. Now that all the theatrics are over it is time to get back to reality.

I was surprised last night not to hear any exit polling on whether voters are aware of the looming fiscal cliff. I am not suggesting that awareness would have necessarily changed anything, I am just curious – after all, I am an analyst at heart. I hope voters are aware, because it is serious and it must be dealt with immediately.

It may come as a surprise for Americans to wake up today and realize that there have been things happening in the world during the last few weeks other than storms and elections. GDP growth came in at 2 percent, which was better than expected. Unfortunately when one digs into the numbers you see that 0.72 percent of that growth was due to increased government spending, mostly a 13 percent jump in military spending, which looks to me like stockpiling ahead of the draconian cuts coming from the fiscal cliff. That leaves real GDP growth at approximately 1.3 percent, which is still better than we expected but extremely weak, and if I am correct will mean a drop in future military spending as this stockpile of supplies is drawn down even if the fiscal cliff is avoided.

Yesterday the pharmaceutical benefit company Express Scripts reported earnings. They beat expectations but cautioned analysts that next year’s earnings estimates are too aggressive, citing the weak economy when pressed for rationale. Analysts seemed legitimately surprised, and the stock got hammered. What seems strange to me is that sense of surprise; we get the same data as everyone else, and I don’t understand how people do not recognize the lack of economic activity.

Perhaps it is the housing data, which is the one true bright spot in the economy. However, some are behaving as though housing is going to now return to 2005 levels, and that is not going to happen.

Consumers are also more optimistic, although consumer sentiment is almost always a backward-looking indicator: consumers are usually the happiest when the economy has peaked, meaning that things have been relatively good but are about to get much worse. Likewise they are the saddest when the economy bottoms, meaning things have been bad but are actually about to improve. In other words, consumers are almost always wrong. Today I believe that is doubly true, because it is hard to understand optimism in the face of an enormous tax increase. My guess is that most Americans simply have not realized that their take-home pay is about to get significantly reduced come January 1 if nothing is done to avert the fiscal cliff. Either that or they are very optimistic that our leaders will reach a compromise by year-end.

Don’t get me wrong, I hope that optimism is well-placed. However, in my business it pays to hope for the best but plan for the worst. Investing is about making decisions today about the future, which is by definition unknowable. As a result we must deal in the world of probabilities. There must be some probability that no compromise is to be had and that we will indeed go over the cliff. This brings us to last night. The irony is that after billions of dollars spent on ads we are all glad to never see again, we have sent basically the exact same split government back to Washington. The guys who could not agree on anything for two years are now the ones we trust to avoid fiscal disaster. I fear the probability of going over the cliff has been greatly increased.

Beyond the fiscal cliff there is hope. Long-term valuations are reasonable and that is ultimately what drives results, but we must get over this cliff. Caution remains in order.

Chuck Osborne, CFA
Managing Director

~Now What?

What should we think about last week’s jobs report? As I am sure most of you have heard by now the official unemployment rate is finally below 8 percent at 7.8 percent, according to the Department of Labor’s Bureau of Labor Statistics. Since the release of the report the talking heads on CNBC have become screaming heads, and people such as the former Chairman and CEO of GE, Jack Welch, have accused the Administration of fudging the number for political reasons.

For the record, I do not believe there is any grand conspiracy to fudge the numbers. The problem with conspiracy theories is that they assume two things: competency and the ability to keep a secret. It would take an unbelievable amount of skill to fudge the numbers and actually get away with it, with hundreds of economists, market strategists and reporters checking every detail of your work. Then it would take an inhuman amount of humility not to have one person involved “tweet” it out to the world or update his Facebook status to read, “Just fooled America into believing unemployment is getting better.”

With all respect for Mr. Welch’s business career, the conspiracy theory just does not hold water. However, I understand the reaction; something strange happened in last week’s data and it was not just the unemployment report. For those like us who follow economic data daily, there seemed to be a pattern developing: starting around May the formerly mixed economic data started to be all negative. Manufacturing especially fell off the cliff. The Empire State manufacturing report was horrible. Shippers from Fed Ex to Norfolk Southern have warned on earnings, twice in the case of Fed Ex. The August jobs report was horrible. The only “good” data was coming from housing and frankly all that means is that we finally seem to have hit a bottom.

Then out of the blue came the Institute for Supply Management’s (ISM) manufacturing survey which showed a modest expansion in manufacturing activity, especially in new orders. This was taken as a big positive since the expectations were for continued slowing. After that we received another ISM report on the services sector that once again was better than expected. Then, finally came Friday’s big news about the unemployment rate. What has happened?

It seems to us that only one of two things could be occurring. One possibility is that we, and most other market watchers, have been wrong about the economy and we simply had a summer break in activity and now we are back to work. The recent data could support this outcome and the return to 2 percent growth – still slow, but better than the 1.3 percent of the second quarter and the seemingly even slower activity in most of the third quarter.

The other possibility is that these reports are statistical blips caused likely by the looming fiscal cliff. When one digs into the employment numbers, there were 114,000 jobs created in September. The population grew by 206,000, so jobs created obviously did not by itself lower the unemployment rate. What lowered the rate is that revisions added approximately 800,000 jobs of which approximately 600,000 appear to be part time. This is why the “underemployed” rate remained the same at 14.7 percent.

So we have a sudden increase in manufacturing orders,orders and a large increase in the number of part-time employees – many of whom are typically temporary. If I were a procurement officer in the Armed Forces and saw the cuts coming to my budget next year should the fiscal cliff not be averted, I would be stock-piling. If I were a civil servant with projects to be done I would be doing everything possible to get them done by year-end, including hiring part-time and temporary workers. In other words this could be a natural reaction to the impending fiscal cliff.

How will we know? We believe the answer will be found in third-quarter earnings reports and company forecasts. If things are as bad for companies as we previously believed, then it is likely that these improvements are illusionary blips. If, on the other hand, companies surprise on the up-side, or more importantly report signs of improving activity, then this may be a real improvement. We hope for the latter but the prudent course is to be prepared for the former. With the International Monetary Fund announcing yesterday that the risk for another global recession is “alarmingly” high, that unfortunately seems like the safer bet.

Chuck Osborne, CFA
Managing Director

~Figures Lie and Liars Figure

“Our destiny is frequently met in the very paths we take to avoid it.”
– Jean de la Fontaine

We are all products of our experiences. Sometimes in life we, or someone around us, make a mistake whose consequences are so painful we promise we will “never do that again.” Too often in those circumstances we end up making all new and sometimes bigger mistakes. George W. Bush believed that his father made a mistake when he did not take out Saddam Hussein in the first Gulf War when we had most of the free world by our side. Determined not to make that same mistake, he made all new ones.

Similarly, Ben Bernanke came into the job of Chairman of the Federal Reserve (Fed) largely by his reputation as a scholar of the Great Depression, and specifically all the mistakes that were made by the Fed during that period. He is determined not to make those same mistakes, and as a result he is making all new ones. For those who need some catching-up: the Fed has announced a third round of quantitative easing (QE3). So-called quantitative easing occurs when the Fed purchases bonds, usually Treasury bonds, but this time they will also purchase mortgaged backed securities, in the open market in an attempt to lower longer-term interest rates.

I will get into why I believe this is a mistake and what it means for investors, but first I think it is important to understand why the Fed is doing this now. They are pursuing the strongest measures they have taken thus far since the beginning of the financial crisis because things are not just failing to improve fast enough; things are getting worse. Unemployment came out last week and the headline number seems encouraging. It dropped to 8.1 percent vs. the previous reading of 8.3 percent. However, when one digs into the numbers, that entire decrease is caused by people giving up and leaving the workforce. As Mortimer Zuckerman, chairman and editor in chief of US News and World Report, recently pointed out, when one adds the eight million Americans who have given up and dropped out of the workforce to the scores of people in the category the government calls “underutilized labor,” the real unemployment rate is closer to 19 percent.

On top of this we have the discouraging report from the Census Bureau: 46.2 million Americans now live in poverty, which represents 15 percent of our population. This number was actually down from last year but not in a statistically meaningful amount, so for all intents and purposes it has remained constant. However, median incomes fell by 1.5 percent in real terms.

As we reported earlier, GDP growth, while still positive, is slowing. Manufacturing activity is slowing dramatically. The numbers of people actually out of work are rising. Incomes are dropping. This is no longer a weak recovery. We are in an economic downturn. We will let the academics decide if it qualifies as a new recession, but regardless of titles things are now getting worse, not better.

This is why the Fed is so eager to take action and why their action is so extreme. I believe they are making a mistake. The Fed has tried quantitative easing twice before (two and a half times before if you count the “Twist” program) and thus far they are 0 – 2 (or 0 – 2.5) in actually helping the economy. It did not work before and there is little reason to believe it will work now. To put it simply, interest rates are already at record lows, making them even lower is not going to change anything. That is not the same as saying the former rounds of quantitative easing did not have an impact. They led to strong, although temporary, rallies in the stock market and in commodities.

Here is our scenario of what happens with QE3: The economic activity does not change at all. No consumer or business person is currently sitting on the sidelines because they thought interest rates were too high. None of the real issues – declining incomes, high unemployment, regulatory uncertainty, unrest in the Middle East, the recession in Europe, etc. – have gone away. We do not see how this will help in any real economic sense. In fact it will most likely cause prices at the pump and prices at the grocery store to rise, as its forbearers did. So we will likely end up with a scenario where incomes keep dropping while the prices on things we need to survive day in and day out continue to rise. In other words, we believe QE3 will make things worse in the real economy.

When we put on our investor hat this becomes a difficult environment in which to make decisions. On one hand, everything in the real world is getting worse. On the other hand, cliché’s exist for a reason and “don’t fight the Fed” is a long-time Wall Street cliché. Over the next several days we will be reviewing opportunities to potentially increase market exposure, but we still believe it is prudent to be cautious. All the short-term traders are as happy as can be that they got their wish for QE3. Soon, however, companies will begin reporting third quarter earnings, and all the data points to very painful numbers. The question is, what trumps what? Market momentum and easy money vs. economic slowdown and depressed earnings. In the long run actual results have always mattered, and while that has not been the case this year we still believe it is the most prudent path.

Ben Bernanke is doing everything in his power to avoid the past mistakes that took a bad situation in the early 1930’s and turned it into a Great Depression. Unfortunately in his effort to avoid that destiny he may very well have put us on the road to it. One thing is certain, he is not making the same old mistakes; he is making brand new ones.

Chuck Osborne, CFA
Managing Director

~“We’ll Never Do That Again.”