2012 has gotten off to an interesting start. Over the last three weeks Greek bondholders have stood up and told the world that they are not going to roll over and green light just any EuroZone plan to avoid total collapse. France has been downgraded, as has the European rescue fund itself. Flagship firm Goldman Sachs announced that their revenue and earnings are down more than 50 percent compared to last year. Iran has rattled its saber and threatened to use force to cut off the flow of oil from the Persian Gulf. And, the stock market is off to its best start since 1987. Which one of these scenarios doesn’t seem to fit?

In fairness, not all the news in 2012 has been bad. Our economy does seem to be improving at the margins. Unemployment is below nine percent for the first time in several years, and manufacturing and consumer spending have both notched up a bit. However, corporate earnings growth is showing signs of slowing and the early results indicate fewer companies are beating expectations. Yet, optimism abounds everywhere. This brings to mind one of the more famous Warren Buffett quotes, which, like most of his better quotes, actually originated with his mentor Benjamin Graham, “Be greedy when others are fearful and fearful when others are greedy.”

The problem with 2012, other than apocalyptic visions of the Mayans, is that none of the problems from 2011 have actually been solved. Things have been quiet on the European front and we seem to be following the “out of sight, out of mind” mindset. Unemployment has improved, but then unemployment was improving this time last year. In the meantime earnings growth has slowed. According to Standard and Poor’s, fourth quarter 2011 estimates on the S&P 500 companies are for 6.8% growth, while in October the estimate was for 14.6% growth. Since October the market is up nearly 15% on what everyone expects to be worse earnings. If that seems curious to you, you are not alone.

It is possible, as many optimistic forecasters are suggesting, that we make it through 2012 with no flare-ups from Europe; that Iran is once again just full of talk; that the European recession is mild; and that the rest of the globe, led by the U.S., experiences decent growth. Under this scenario stocks should continue to climb. But, if just one domino falls we will be in for a big shock to the market. Those of us who remember October of 1987 get a little nervous when people start comparing what is happening now to that fateful year.

We believe equity markets will end the year very close to where they began, and in the interim we are likely to witness a great deal of volatility. The probability of a major geo-political issue sending shock waves through the markets seems higher than normal. In this environment we believe caution is still in order.

One of the things we always ask ourselves is, “What if we are wrong?” If we are wrong, then we may very well lag the market in the upturn, but likely still have a solid absolute return. This is a much better mistake than getting killed in a dramatic sell-off.

We believe that domestic large cap equities are the most attractive place to be in the equity market, and we remain cautious on domestic small cap stocks. Developed foreign is the worst place to be, especially Europe, but we think emerging market equities may have bottomed and we are cautiously wading back into these securities.

Fixed income remains the biggest long-term concern, but Treasuries have proven a safe haven in times of distress. They make sense as a diversifier here to protect from the potential market shock. Corporate high-yield and emerging market debt remain the most attractive long-term in the fixed income landscape.

A word of caution: To paraphrase the late, legendary golf instructor Harvey Penick, when we proscribe an aspirin, take an aspirin, not the whole bottle. Graham’s warning to be fearful means to show caution, not panic. That is exactly what we are doing.

Chuck Osborne, CFA
Managing Director

~Be Fearful When Others Are Greedy

How to describe 2011? Many famous quotes come to mind. First, Charles Dickens, with, “It was the best of times, it was the worst of times.” Also the Grateful Dead, with, “What a Long Strange Trip It’s Been.” I think they both work. The only thing I am certain about regarding 2011 is that I – and I suspect many others – am glad it is over.

2011 was as good as it gets for corporate profits. When one looks at the underlying fundamentals of the companies whose stocks constitute the stock market, one would have thought that 2011 would have been the start of a big bull run. Unfortunately the markets were not driven by underlying fundamentals in 2011; they were driven by geo-political crisis. The headlines suggest that it was a flat year, but for most professionals, ourselves unfortunately included, the headlines paint a rosy picture on a brutally volatile and tough investing canvas of a year.

I have written about this dichotomy several times over the last few months, however, the New Year always makes me feel a little more philosophical about the practicalities of the past twelve months. The details of daily activity tend to drown out the big picture of what we are witnessing. In 2011 we witnessed natural disasters in Japan, an uprising of the desire for freedom in the Arab world, and the start of the collapse of European “Social Democracy.”

The situation in Japan is an isolated event, although these disasters always teach us how fragile human existence is in reality. We go through our lives on a daily basis buckling our seat belts, constraining our children in safety harnesses, and sleeping in air-conditioned and burglar-alarmed houses made to withstand earthquakes and hurricane-force winds. Then we are brutally reminded that the forces of nature are beyond our control. This feeling of insecurity may be more meaningful in the long run than the temporary disruption of supply chains.

The other two phenomena that marked 2011 have more lasting potential. Market reactions in the short term are centered on the flow of oil from the Middle East and the flow of credit in the West. However, the Arab uprisings and the European crisis have more in common than just market movements: they both represent the ultimate failure of societal models that constrain the most basic desire of mankind, freedom. It is most obvious in the Middle East as totalitarian dictators are toppled, one by one, by protesters in the streets.

It is equally true, however, in Europe, where freedom was gradually traded for a false sense of security. Totalitarian rule is a harsher means, but regulatory red tape and unrealistic promises of “free” benefits will deliver the same ends: A lack of freedom, a lack of innovation, and a lack of economic progress. There are only two stages of being in nature, growth and decay. Many falsely believe that economic growth is harmful, or that continual growth means always getting bigger, wealthier, etc. This is not true. New growth is needed to replace the old. New growth is needed to survive. The seeds of demise in Europe were sown long before they dreamed of a common currency.

There is hope in this understanding of what we are enduring. In 2012 we will have our own decision to make: Do we continue down the European path to inequality, economic stagnation and eventual collapse, or do we choose the path of freedom as is our tradition? In Europe they no longer have a choice. There is no more money to spend on the regulatory web and its social contracts; regulatory reform is the only option for both reducing the cost of government and stimulating economic recovery. Social contracts have to be brought back to reality for a lack of resources. In other words, freedom will be increased, and as has always been the case, when freedom rises, economies do as well.

In terms of our day-to-day responsibility, much of 2012 will be spent waiting and watching to see how fast Europe will act and what the United States will decide to do in the meantime. At Iron Capital we are still working on our own forecast, but it is clear that volatility will continue. These days may seem dark for many, but there is hope for the longer term as we enter this new year. It may take some time, perhaps all of 2012 and beyond, but there is a reasonable probability that 2012 will mark a turning point in the trajectory of the West, away from central control and back towards freedom.

Of course it may end differently, but it is a new year so let’s be optimistic.

Happy New Year!

Chuck Osborne, CFA
Managing Director

~2011 Year-End Review

Some of you may be wondering why we have not pontificated on all the market movement of late. But the more things change, the more they stay the same:  Since we last communicated, markets rallied strongly and are once again retreating.

The latest market rally was sparked by better-than-expected economic news and the appearance of progress in Europe. It is the same story we have been talking about all year: The economic data is not changing, but the expectations continue to jump wildly. The predictions had grown dire, and then holiday shopping turned out to be okay. Retailers did better than expected after Thanksgiving, and seasonal hiring has temporarily lifted unemployment. This week more retail numbers have come out showing roughly 2 percent growth, in line with all the data we have been seeing, but this time expectations have grown and now the same numbers are a disappointment.

In the meantime, the Federal Reserve came to the rescue in Europe, making it easier for European banks to borrow U.S. dollars. Shortly thereafter the leaders in Europe had yet another emergency meeting and this time came out with a signed document. This document appears to be every bit as valid as the signed document Lucy gave Charlie Brown assuring him that she would let him kick the football, right before she pulled it away at the last minute, causing him to fall flat on his back.

In case you have not seen the agreement, it is seven pages long, mostly due to the intentionally left-blank spaces throughout. It contains great proclamations like, “We commit to establishing a new fiscal rule.” It then lists elements that should be in the rule, but no rule itself. It proclaims that existing rules will be reinforced. In other words, this grand agreement is little more than an agreement to make a future agreement, to which at least one EU country, The United Kingdom, has said thank you, but no thank you. This week the market has seemingly seen through the empty words and we are once again on the downward path.

There is one force that could help us this time around and possibly keep a rally going, if only temporarily. The New York Stock Exchange still refers to the traditional winter solstice celebration as Christmas and not its new, more politically correct name, Holiday. I don’t think it is because Wall Street is full of Christian piety; I think it has more to do with superstition and the mythical “Santa Claus rally.” You see, the big guy in the red suit does more than deliver goodies to nice boys and girls around the world. Every year about this time he lifts the spirits of investors, and we seem to get a little rally. The Santa Claus rally is not guaranteed; there have been years when Santa brought us a lump of coal, and that is a possibility. But in the spirit of the season, let’s hold out hope.

We have a tough road ahead of us in 2012. Europe will be in recession if they are not already, and if it gets bad over there, it will spill over to us. So let’s pull for Santa. It may be temporary and meaningless in the long run, but in the short run Santa rallies are fun, and we’ve all been good this year.

Chuck Osborne, CFA
Managing Director

~Market Volatility? Same Old, Same Old

“Perception is greater than reality.” I hate that saying – I’m a reality guy. I once tried to start a counter movement to political correctness called “actual correctness,” but I didn’t get very far. It seems people actually are not that interested in what is actually correct. People are interested in having what they want to believe being affirmed.

For example, if you follow professional golf you have probably heard that Tiger Woods is back. The headlines suggest that he won the President’s Cup for the American team. What actually happened was that Tiger won two matches and lost three matches over the course of the competition, and one of those losses was the worst in President’s Cup history. However, there are a lot of people, especially in the sports media, who desperately want Tiger to be back. So when he shows glimmers of the old Tiger in one 14-hole stretch, he is “back.” Reality, unfortunately, is harder than that.

More importantly to our endeavor, over the last month there have been several proclamations of progress on the European debt crisis. European leaders met and announced a deal, and markets cheered. When we looked for the details, there were none. Part of the plan was to ask the Chinese for money, but when they asked for details there were none. The reality is there was no deal, just the most basic of outlines to make a deal. When the Greeks and Italians did not like what their neighbors were asking them to give up, they “shot the messengers” and both countries now have new leaders. The markets cheered this as progress, but is it really? Does a new head of state change the anemic GDP or the overwhelming amount of debt? We don’t think it does.

In the meantime our own deficit problems were being completely ignored by the media until the last few days, and the markets seemingly believed the Super Committee would magically live up to its name. There seemed to be an assumed consensus that the same politicians who could not agree on anything a few months ago would somehow come out of the committee chambers arm-in-arm, singing Kumbayah. When that did not happen the market seemed surprised; we were not.

Our caution to brace yourself a few months ago has held true, and our approach thus far has worked. All of our clients’ portfolios have faired well when the market has risen and have done far better than the market when it has fallen in this volatile environment. We will continue to brace ourselves until the reality on the ground changes for the better, and that will happen. Knowing when it will happen is a guessing game, but this too shall pass and we will get through it.

As we approach our national day of thanks it is appropriate to remember that our glasses are still half full. We all have much to be thankful for, and as is our tradition I will list some of the things for which I am thankful this year.

1.  I am thankful that my ancestors were kicked out of Europe and thus I had the good fortune to be born an American.
2.  I am thankful for my children, Charlie, who just turned four, and Mary Frost, who is one year old. Seeing the world through a child’s eyes is a marvelous thing. When I get home each day, my son and daughter have no idea what the market has done or what kind of mess this generation of politicians is leaving for them. I am grateful for that innocence and hope they are fortunate enough to keep it for a long time.
3.  I am thankful, as always, for Mama’s Pumpkin Cheesecake – mmm, mmm.
4.  I am thankful for my loose pants still being loose, clean and ready for Thursday’s feast.
5.  Finally, I am thankful for you, our clients. Our relationship with you is what makes this enterprise worthwhile. Thank you for your continued faith in Iron Capital.

On behalf of the entire Iron Capital family I wish you and yours a very Happy Thanksgiving.

Warm Regards,
Chuck Osborne, CFA
Managing Director

~Count Your Blessings

On November 11, 1918, in the French town of Compiegne, the Allies and Germany negotiated cessation of hostilities on the Western Front effective at 11:00 a.m. Paris Time. At the eleventh hour on the eleventh day of the eleventh month, the War to End All Wars was over. Armistice Day, celebrated throughout the western world, was a time to remember those who made the ultimate sacrifice in fighting against the Central Powers of Europe to defend our freedom. After World War II, the United States changed the name of the holiday to Veterans Day and expanded its purpose to celebrate not only those who fought the Kaiser, but also all American veterans who have fought to maintain our freedom.

It is somewhat ironic that we celebrate this Veterans Day, 11.11.11, just a few days after the German Chancellor has made a call for a “New Europe” and the world is once again threatened by European excesses. This time there has been no cannon fire, no battalions have marched, and no tanks are in the streets of Paris, but the lack of fireworks does not change the overall script. Sure, there are differences — Germany likes to change dance partners from time to time. In World War I it was the Central powers of Austria-Hungry and the Ottoman Empire, while in World War II they preferred the Axis powers of Italy and Japan. Today it is France and the Euro Zone, strange as that may seem. The goal is, however, the same:  to control the whole of Europe in the name of centralized governmental power. If successful Germany yet may get the European dominance they seem to have wanted since the day their barbarian ancestors destroyed what was left of the Roman Empire and cast the world into Medieval darkness. If they fail, Europe will once again be trying to piece itself together in the aftermath of another ill-fated attempt to bring the continent under central control.

This saga, while gripping, is wreaking havoc with the financial markets. We foresee one of two outcomes:  Germany could get its way, with a much stronger Eurozone that would not only determine a country’s currency but also would have great control over fiscal policy; or the Eurozone, and possibly the entire EU, will collapse. Either scenario could work in the long term, and it is not our place to judge which is best, but getting to either point is going to be politically painful, and that political pain will continue to spill over into the markets. We will see up days, even short rallies, but it is hard to see how our markets go up with an economy the size and importance of all of Europe in such a political mess.

The collapse of Greece has been distracting markets for more than a year. Greece is much like the sub-prime mortgage market — alone neither was big enough to really cause pain, but they were not alone. The mess in sub-prime was actually in the whole mortgage market, just as the mess in Greece is in all of Europe. Sub-prime and Greece were simply where the problem was at its worst and therefore were the first dominos to fall. Italy is now the concern. Italy has the world’s third-largest bond market, behind the U.S. and Japan. This makes Italy too big to be bailed out and a real threat to the global economy.

The mortgage mess was really just a symptom of larger issues, and this debt crisis in Europe is just the same. In our case it was the must-have-it-now, free-spending culture that caused people to buy houses they could not afford, financiers to sell mortgages that should not have been sold, and elected officials and regulators to push for more home ownership. In Europe the issue is the entitlement culture that sees work as a distraction from life instead of a meaningful part of who one is as a person. Europeans have been far too comfortable with the regulatory nanny state and the unsustainable social contract that goes with it. Sacrificing freedom for a false sense of security may feel better than being subjected to a tyrant, but in the end neither is sustainable. People are meant to be free.

This brings us back to the purpose of this day. As we honor those who have fought to keep us free, let us not forget that freedom is worth fighting for, and that freedom is what has made this country great. Regardless of whether one chooses to use freedom to work on Wall Street or occupy it, or to go to tea parties or ridicule them, one owes that freedom to the men and women who have served this country in its Armed Forces.

Today the entire Iron Capital family solutes all veterans of the U.S. Armed Forces and thanks you for protecting our freedom. May God bless you, your families and the United States of America.

Chuck Osborne, CFA
Managing Director

~The 11th Hour, of the 11th Day, of the 11th Month