“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.”

Managing Director

~The Price of Everything But The Value of Nothing

I first realized that I think differently than most people when I was a senior in high school. I was in Political Science class with Dr. Davies – one of those exceptional teachers that really made a difference in a lot of kids’ lives, including mine. Dr. Davies had asked the class to research the War Powers Act and be prepared to discuss whether it was constitutional. He began the class with a quick poll, and it turned out I was the only one in the class who thought the act was not constitutional. He allowed my classmates to make their arguments first, and they all talked about how it made sense in a modern, fast-paced world to allow the Commander in Chief to commit our Armed Forces without having to wait for Congress. They made very logical arguments. Finally Dr. Davies looked at me and asked me why I disagreed with my classmates. I told him that I didn’t disagree, and then I apologized because I must have misunderstood the assignment; I thought I was asked to determine if the act was constitutional, not whether I thought it was right. What happened next I will never forget: Dr. Davies, who had been leaning back on his desk, jumped to his feet and started to applaud. He announced to the class that I got the only “A” on our assignment, not because I was correct – I don’t recall if he ever told us the “right” answer – but because I was the only one to get the point of the exercise.

The point of reliving this story is not to start a debate with my many attorney clients and friends about our Constitution, – a debate I would surely lose; the point is that I often believe we get the wrong answers in investing, and life for that matter, not because the answers we get are necessarily incorrect, but because we are asking the wrong questions.

Yesterday the market rallied strongly based on a short speech by Mario Draghi, president of the European Central Bank (ECB). He told a group of investors that the ECB can and will do what is necessary to save the Euro. I have not seen the entire transcript of his speech, but based on the reaction I would not be surprised if he wrapped it up by thrusting both fists in the air and declaring, “I am invincible!”

Well, Draghi is not invincible, and saving the Euro may or may not be a worthy cause, but it is not going to solve the real issues. When Draghi made his statement what he meant is that the ECB still has the ability to loosen monetary policy and reduce interest rates. There has been similar talk from our Federal Reserve Bank (Fed), that they might provide some form of easing – QE3, or something new. The problem with these actions is that they miss the point. We do not have a liquidity crisis, either here or in Europe. The globe is drowning in currency as every major central bank in the world has their pipes wide open and it still has not jump-started the economy. Opening the pipes further is not going to help.

Central banks are very good at liquidity problems. If there was a lack of liquidity the central banks around the world could act, just like Milton Friedman and Anna Swartz argued they should have during the Great Depression, and it might work. Unfortunately, the economic world lost Anna Swartz earlier this summer, but before she left us she warned that policy makers were responding to the wrong crisis. It is not that their solutions are inherently incorrect – after all she co-authored this playbook – but they are simply trying to answer the wrong question.

The question for policy makers is not whether the ECB can “save” the Euro, but rather, Can Europe enact the necessary reforms to rebuild economies that can grow and be self-sustaining? For investors the right questions are, How deep is the recession in Europe going to be, how long will it last, and how much of it will spill over to our shores? Thus far this quarter 60 percent of Standard and Poor’s companies have missed on revenue, largely due to slowing sales from their European customers. Earnings have been somewhat more positive on a relative basis, but this is largely a result of lowered projections, which the market has yet to price in.

It seems like there are some bulls out there grasping on every seemingly positive straw. Unfortunately, the ECB can’t solve the problems in Europe, and the Fed cannot solve the problems here. It looks like a lot of short-term traders are missing the point: Investing isn’t about monetary policy; it is about corporate profits, which are a function of economic growth. Those who keep waiting for central banks to ride to the rescue are asking the wrong questions.

Warm Regards,
Chuck Osborne, CFA
Managing Director

~Missing The Point

Volatility is making a comeback. I often joke that investors never get upset about upside volatility, but if they are wise they should. Risk is risk, and while it is exciting to take risks when they work out, eventually one will experience the downside.

This last quarter has worked out pretty much like we thought it would. The crisis in Europe once again grabbed headlines and the markets gave up much of the gains from the first quarter. We were well-positioned in all of our strategies for the downturn and, as expected, outperformed. Then a funny thing happened: On the last day of the quarter the market went up by 2.5 percent. That is some upside volatility. What caused it? Some believe it was a positive reaction to the news that the EU is going forward with creating a banking union, so banks can be bailed out directly by the EU instead of by the individual countries. Others, more cynical but probably more accurate, believe a lot of traders needed to cover their short positions before client statements went out and/or they left town for their 4th of July vacations.

Regardless of the reason, that one day made the entire quarter look significantly different. In our case we went from significant outperformance to being roughly in line with the market, as we had outperformed on the downside but underperformed on the huge up day. It is frustrating that one day can be so important from a client visibility standpoint. By tradition and regulation investment managers report on a calendar quarter basis, but is that three month period any more valid than the three month period that ended a day earlier? The frustration leads to a phenomenon known as “window dressing.” Knowing that clients get to see what they are doing at the end of every quarter, some managers will make trades to make their portfolio look better. They may sell controversial holdings, which are likely their best ideas, in order to not offend. They may purchase big winners to make their clients believe they owned them all along. If a manager gets a big lead on the market half way through a quarter they may become a quasi-index fund for the remainder of the quarter in an effort to “book” their relative performance.

We don’t engage in these practices, and for the record I don’t believe window dressing is as widespread as the rumor mills insinuate. However, there are some who do it, and anyone who has been in this business for a number of years understands the temptation. The problem is two-fold. First, a manager who conducts himself in this manner is putting his own interest before that of his clients. Risk to the client is losing money; risk to the money manager is underperforming the market. A manager who gets ahead of the market and then changes his portfolio to “book” that relative gain is reducing his risk, but in all likelihood increasing the risk of the client.

Secondly, it is just a day. The unfortunate timing that gives days like this seemingly greater importance is illusory. The reality is that markets go neither up nor down in straight lines; we often have big up days in down markets and vice versa. Regardless of which story you believe – that the market rebounded because of EU action or that it was all window dressing – both effects are temporary and will be undone within a week or two.

In the case of window dressing it should be obvious why it is undone. We are now in July and three months away from most managers having to come clean to their clients, so they can once again position their portfolios as they wish versus what they wish to show their clients.

In the case of Europe my prediction may be a little more controversial. However, nothing has really changed. The latest moves to assist the banks will put off catastrophe a while longer, but once again the proverbial can has just been kicked down the road. In the interim Europe’s recession is still here, and investors and economists are just beginning to understand the severity of the situation. China’s economy is slowing as is ours, when we were already not far from recession.

The reason this crisis is important to investors is that we invest in companies that must operate their businesses in the economies that are impacted by an overwhelming amount of debt. The economies are slowing, therefore earnings will be slowing, and therefore the companies we invest in will be worth less. This dynamic has not changed. Watch for earnings reports, as they are not likely to be very encouraging.

We will get through this crisis, but it is not going to end neatly on one day at the end of a quarter. It will be a process that takes time. Recovery will most likely be marked by a market slowly climbing a wall of worry, not 2.5 percent jumps of temporary euphoria.

Warm Regards,
Chuck Osborne, CFA
Managing Director

~What A Difference A Day Makes…or Does It?

Spanish Banks are getting bailed out…so why is everyone so gloomy? It seems that after two years of bailout after bailout, market participants have finally realized that one cannot escape indebtedness by borrowing more money. It is hard to believe it took this long for investors to figure that out, but then again it seems that politicians and even some economists are still having trouble with this concept.

It is possible that this latest bailout has made obvious the unholy alliance between big banks and big government. Make no mistake, this €100 billion bailout was targeted for Spain, not Spanish banks. Multiple times over the last several weeks the Spanish government has warned that they were being cut off from the financial markets and would no longer be able to borrow money. The solution: prop up Spanish banks so they in turn can continue to loan money to the Spanish government.

It is a vicious cycle. Governments have only two choices for collecting revenues: they can tax their citizens or borrow the money, and most of the borrowing comes from financial institutions. Under normal circumstances with manageable debt levels this is not an issue, but as the debt levels get out of control, as they have in Europe, fewer and fewer investors are going to be willing to loan money, and if they do they are going to demand higher and higher interest payments to justify the risk. The exception is big banks that have a dual relationship with the government. The government is a large client, as they have loaned much of their capital to the government, and the government is their boss as they regulate the banks. One can see where conflicts may arise.

Suddenly in Europe the call is for a Europe-wide banking union. Why? Because market participants are starting to figure out that most of Europe’s banking problems are from the fact that the banks have loaned money to various European governments. Sure there are real estate losses in Spain and Ireland, but the biggest issues throughout Europe are related to sovereign debt. The solution to banks being in trouble is for the government to come in and back-stop the banks. So follow this: the banks are in trouble because they have loaned too much money to the government that is in debt way over its head, and the solution is for the government to bail them out? Increasingly this is looking ridiculous to anyone who is actually paying attention.

This brings us to Herbert Stein’s Law: “If something cannot go on forever, it will stop.” Debtors, including governments, will hit a point when lenders simply stop lending them money. The problem is that it is next to impossible to know exactly when one will reach that point. So while it is a good thing that Spanish banks are being bailed out, avoiding that tipping point for Spain, the market sees that nothing really seems to be learned. Every step in this crisis has been about Europe’s leaders looking to find more money to borrow instead of fixing the problem. Eventually Europe must live within its means and start reducing debt instead of adding to it. The current situation cannot go on forever and therefore will stop. The question is: does it stop voluntarily with European governments making difficult grown-up decisions, or does it stop by force when there is nothing left to borrow? The former would be less painful, but thus far the latter looks more probable.

Chuck Osborne, CFA
Managing Director

~Borrowing Your Way Out of Indebtedness