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?

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?