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?

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