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

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?