Since we last stirred you with our insights on austerity, Europe’s woes have continued with almost all of Southern Europe now reporting negative GDP growth; JP Morgan has embarrassed itself with a loss that CEO Jamie Dimon called stupid; and markets have reacted as we thought they would.

While JP Morgan’s highly publicized loss has once again surfaced the anger many feel towards the titans of Wall Street, the coverage has really added more heat than it has shed light. The complicated nature of what occurred makes it difficult to understand, but I believe it was Albert Einstein who once explained that if you cannot explain a concept so that a kindergartener can understand it, then you really don’t understand it yourself. This is why we always start out investment education sessions by explaining the simple truth that there are only two ways to invest: You either own something that you believe will increase in value while you own it, or you loan money to someone who you feel confident will pay you back plus interest. That is it. When you own something – it could be stock of a publically traded company, stock of a privately traded company, a bar of gold, a work of art, or baseball cards – you had better understand what it is you own and what it is really worth. When you loan money –as simple as a direct loan to a family member or as complicated as the collateralized debt obligations (CDO’s) that have JP Morgan sweating – you had better understand to whom you have loaned and what kind of credit risk you are taking. JP Morgan evidently did not understand just how much they had loaned out, which, as Jamie Dimon said himself, is really just stupidity.

Of course the root cause of all this market turmoil and JP Morgan’s trading woes is the ongoing saga of Europe. In our last Insight I said there is no alternative to austerity. Of course there are those who claim that there is an alternative; they say Europe – or any of the individual countries who wish to exit the Euro and re-establish their own currency – can simply turn on the printing press, so to speak, and print enough money to pay all of its bills. This is often referred to as devaluing the currency because it causes a high amount of inflation.

They are not wrong exactly, but in reality austerity and devaluation of currency accomplish the same thing. Devaluation just has the political advantage of being dishonest. You see, if you are a retiree in Greece receiving a state pension check of €2,000 per month and the government says we can’t afford this payment and we must cut your check by €500, that is austerity. If they instead decide to inflate their way out, you will still receive a check for €2000 but it will be worth only €1,500 or potentially much less because of inflation. It is still the same pain, it is still austere, it is just less honest.

The thing the advocates of turning on the presses don’t understand is that governments do not create money; they print currency, but that is not the same thing. Money is an economic mechanism that allows one to store value. Just as all investing boils down to two basic roles, owner or lender, all economic activity ultimately boils down to barter. Our clients are a diverse group: some practice law, some run hotels, some load and unload cargo from ships, but all of them produce economic value. Money allows us to spend our time doing whatever it is we do best. I get to research financial and economic data and make investment decisions, and not worry about planting crops or hunting for meat or building my family’s house. You, our clients, value what I do and you pay me for it. I can then exchange that value for things my family and I need, like food and shelter. We all do this. If the government decides to greatly increase the amount of currency in circulation, that does not increase the value of my services.

My father grew up in the depression and he is fond of telling us stories about how he walked barefoot five miles to school, up hill both ways, often in knee-deep snow. (I think that is how it goes; to be honest his children stopped listening a long time ago.) He also talks about a loaf of bread costing a dime. When the baker bakes that bread he creates value. When my father was a child, that value could be stored in a dime. A loaf of bread is still a loaf of bread and it is no more valuable today than it was then; if anything it is less valuable, as we are a much more prosperous society today. My grandparents wouldn’t have thrown away any end pieces while struggling to feed seven children during the depression. However, today a loaf of bread costs $2.31 according to government data (and a lot more than that if you buy the whole wheat bread we eat at my house). Bread has not changed in value, but our currency has changed, and it stores much less value today than it did when my father was young.

Southern Europe has consumed much more economic value than it has created. It must find ways to pay back that debt. You can call it austerity or you can call it devaluation of currency but either way, life will be austere and markets will be disrupted. Austerity is the reality of Europe and it must be faced sooner or later.

Chuck Osborne, CFA
Managing Director

~Austerity 2, Europe’s Mess and JP Morgan’s Embarrassment

The economic news of late has not been good. Last week the UK officially went into recession, followed this week by Spain. At home we continue to receive mixed signals. Last week’s durable goods report showed a significant pullback, followed by a GDP report worse than most expected, showing the economy grew at a slow 2.2 percent rate in the first quarter. We received a better-than-expected report from the Institute of Supply Management, which stated that manufacturing expanded in April. Interestingly, the expansion is the highest since March of 2011, right before the last attempt at recovery stalled. Based on all the other data, it seems likely to happen this time as well.

I wish I could come up with a better scenario, but when durable goods orders are down, meaning consumers are buying fewer manufactured goods, and manufacturing activity is higher, meaning more goods were manufactured, the signal for the future is, “slowdown ahead.” I know that I am beginning to sound like a broken record, but this is what a 2 percent growth economy looks like: fits and starts, and good news followed by bad, but little real growth.

In Europe things are much worse than most expected, although we never understood the optimism in the first place. It has become popular to blame the whole thing on the austerity measures taken by the troubled European governments. The problem with this theory is that it ignores both the actions that got Europe in this mess at the outset, and the current reality that the European nations are bankrupt. I really believe that much of the denial regarding Europe has to do with the fact that we are witnessing the collapse of social democracy, much like we witnessed the collapse of its more pure cousin, socialism, twenty years ago, and there are many to whom this realization is an anathema.

Unfortunately for those who want to blame austerity, when you have spent all the money you have as well as all the money people are willing to loan you, then you are bankrupt. Bankruptcy brings on a very austere reality. The long-term solution is to learn to live within one’s means, but in the short term, pain is unavoidable. Those who champion less austerity or even more stimulus are correct about reducing the immediate pain, but they only dig the hole deeper, leading to even more pain down the road. Borrowed money must be paid back.

I often think that John Maynard Keynes must turn over in his grave every time the proponents of never-ending spending use his name. The thing politicians don’t seem to understand about Keynes’ theory on the role of government in smoothing capitalism’s rough edges is that it was intended to be a two-edged sword. Yes Keynes believed governments should run deficits during economic downturns in order to stimulate the economy, but he paid for those deficits by running surpluses during the good times. His idea was to smooth the cycle, which in theory would not only reduce the pain of recessions but also reduce the reward of boom times. Keynes knew that there was no such thing as a free lunch.

Unfortunately, many politicians who claim to be following his theories do not seem to understand this basic principle. (Interestingly, one of the reasons economists believe Keynesian stimulus has never worked in reality as he thought it would is because the masses are smarter than he thought and intuitively know that borrowed money must be paid back.) If you ignore this reality long enough you become Greece or Spain or soon the whole of Europe. Those who call for less austerity are simply in denial about the seriousness of Europe’s situation.

The markets are just beginning to pay attention. The silver lining is that this scenario – recession in Europe and anemic growth elsewhere – is exactly what we thought would happen, and we believe our portfolios are well-positioned to ride out the impending storm. This storm, like all storms, will pass, and good times will return, but the storm must come. Blaming the medicine will not cure the disease, and holding back the storm will just make it bigger. Austerity is not fun, and will not be popular, but ultimately it is the only way out.

Chuck Osborne, CFA
Managing Director

~Austerity

Ben Bernanke, Chairman of the Federal Reserve (Fed), gave a speech on Monday that sent the equity markets skyward. He announced to the world that he is going to keep the peddle down and the presses rolling:  loose monetary policy is here to stay. The markets applauded, but should they?

There is another way to interpret what Bernanke is telling us:  The economy is still in trouble. We have been hit with a lot of encouraging news over the last few weeks, especially with improving unemployment numbers. However, the Fed is concerned that these recent gains may not be sustainable. Unfortunately, we would have to agree.

Europe’s problems are not going away even if the media decides not to report on them when there are other more exciting things to cover. In Europe once again there are calls to increase the ever-growing bailout fund, and once again Germany is saying, “Wait a minute.” Italian and Spanish yields are creeping back up. Although the new Italian government led by Mario Monti has introduced some brave, and needed, reforms of the Italian labor market, those reforms are being resisted by the powerful trade unions. If Italy cannot overcome that resistance it will likely follow the path of their neighbor, Greece, with much greater consequence to the rest of the world.

China’s growth is slowing perhaps more than we realized. We have been very hesitant to jump on the anti-China bandwagon, but there are certainly signs that the world’s economic growth machine is slowing down. China is in the middle of an economic transition. Factory wages have grown dramatically and have encouraged a shift from China being simply being a cheap source of manufacturing for the developed world, to becoming a self-sustaining, consumer-driven economy. This maturing process may come with some growing pains.

Then of course there is the Middle East. What is going to happen between Iran and its neighbors is anyone’s guess, but we deal in the world of probabilities and a military conflict of some sort seems like a fairly strong probability. That will not go over well with oil prices, and if the already high price of oil spikes from current levels, all economic recoveries could be off.

This is the world Bernanke sees. Unfortunately keeping monetary policy loose will not help with most of the risks. This, however, is the problem with the Fed’s dual mandate of stable money and economic growth for low unemployment. The Fed must realize that since the end of the financial crisis its policies have not been effective, but what choice do they have as long as their mandate is to promote growth? It is increasingly clear that the problems our economy faces cannot be solved through monetary policy alone.

Markets cheer the news that money will continue to be printed, but this knee jerk reaction could quickly move the other way when investors start to understand what Bernanke and the Fed are really saying. They are saying that despite all their efforts things are not getting better. That is not a bullish message.

Over the past month the market bulls have been saying that the U.S. economy is picking up and that we can be a catalyst for global growth once more. Bernanke just told us that isn’t going to happen, and we think investors should listen.

Chuck Osborne, CFA
Managing Director

~What Is The Fed Really Telling Us?

Durable goods orders fell the most in three years and your house is still losing value, but don’t worry because consumers seem happy about the whole situation. These were the Strange Bedfellows that greeted us this morning with the release of durable goods orders, the Case-Shiller Home Price index and the consumer confidence index.

The markets, as of the moment I am writing this, seem to be keying on the last report, which is odd to me. The first two reports measure actual behavior, while the latter simply reports attitude. Don’t get me wrong, I am glad people are seeing the glass half-full, but does it really matter? I also wonder if it is accurate. The data for the consumer confidence report stops on February 15; since then, the average U.S. motorist has seen the price of gas rise 20 cents per gallon.

At Iron Capital we have always paid more attention to what consumers actually do rather than how happy they are while doing it, and I see no reason in this morning’s reports to question that wisdom. The cycle we have been talking about for the last few years continues. We had seen positive economic reports, especially on the employment front, and all of a sudden everyone thinks recovery is around the corner. Then Europe got serious again for a moment yesterday, and durable goods orders drop – don’t be surprised if there is talk of a new recession right around the corner. Neither reaction is correct. The truth remains that this is what sluggish growth looks like: Two steps forward and one step back.

Meanwhile the front page of The Wall Street Journal was covered with talk of insider trading. Since 2009 the U.S. Government has charged 66 hedge fund employees with insider trading, winning 57 convictions. They reportedly have 240 people under investigation and have deemed 120 of them “targets,” meaning they have found some evidence of wrong-doing and are trying to build their cases.

It is a little ironic that this headline comes shortly after the news that the investing community lost a legend on February 19: Walter Schloss, 95, lost his battle with leukemia. A few years ago I was asked by a client if I idolized Warren Buffett, because I quote him so often. I explained that I quote Buffett for two reasons: first, because he is extremely quotable; and second, because people actually know him. If I were to idolize any Benjamin Graham disciple, it would be Walter Schloss. My client responded by saying he had never heard of Mr. Schloss, to which I said, “Exactly.”

Schloss is most famous for having shared an office with a young Buffett when they were both working for and learning from Benjamin Graham. Buffett also used him as an example of a “Superinvestor” in his famous 1984 speech. Schloss was the embodiment of the anti-Wall Street money manager: He paid no attention to analyst reports, and didn’t wish to meet with management; he simply went to published financial reports and did the work himself, searching for great investment values. With zero insider information he managed to beat the market by more than 6 percent per year from 1955 to 2002 – a track record that rivals that of his more famous former co-worker.

Walter Schloss was proof that there is an alternative to back-room deals and insider games. He proved by example that investment success does not necessitate selling one’s soul. Deep in the Wall Street Journal article about the epidemic of insider trading there is an interesting tidbit: The FBI agents investigating these allegations were quick to note that the wrong-doers represented no more than 1 percent of the investment management industry. I think Walter would be glad to hear that.

Chuck Osborne, CFA
Managing Director

~Mixed Economic Data, Insider Trading, and The Loss of A Legend

Do you ever wonder why some stories get a lot of press and others, which seem more important, do not? I read The Wall Street Journal, The New York Times and The Washington Post daily, and I get constant news updates on economic issues, specifically on all of our holdings. Over the last few years I have become increasingly shocked when stories are seemingly ignored, and perhaps more importantly how stories are spun, by the mainstream media. The news you don’t hear is often about the issues and events that have the most significant impact on your portfolio.

For example, as we celebrate the announcement of yet another bailout to Greece, we seem to forget that the entire European debt crisis began with Greece admitting to fraud. Greece falsified its financials to gain admission into the Eurozone. That lie may well throw the western world into renewed financial crisis. George Soros has said the wave caused by Europe’s current fiscal situation will make the 2008 financial crisis seem like a ripple in a pond. Four years after the financial crisis, angry protestors still want justice for greedy bankers; where is the outcry for justice to be served on greedy Greek politicians?

It would have been bad enough if the fibs had stopped there; however, Greece has promised austerity measures in order to secure past bailouts, but has yet to deliver on most of those promises. This past week one Greek politician was quoted as saying he will vote for more austerity to secure this new bailout from the EU, because Greece needs the money and he knows they won’t actually make the cuts. Again, barely mentions in the mainstream media.

Back at home our government has been operating without a budget for three years now. The Senate has not passed a budget in that time, despite the fact that they are legally required to do so. One could blame this on gridlock, perhaps, but the Senate, led by Harry Reid, is under Democratic control, and for two of these years the House was under Democratic control as well. I have seen but one short article which indicated that Reid has no intention of even attempting to put together a budget this year. This is historic; why isn’t the press all over it?

Earlier this month Secretary of Defense Leon Panetta, who may just know a thing or two the rest of us don’t, said publicly he believes Israel will attack Iran by spring. Press coverage relegated to briefs.

John Corzine, the former governor of New Jersey, and his team at MF Global have evidently stolen between $1.2 and $1.6 billion from their clients’ accounts. While he is no Bernie Madoff, this still puts Corzine in some lofty company relative to white-collar crime. Barely a mention.

I have no solution for the short-comings of our modern media, but there is something we can do as investors: pay attention to the big stories buried on the back pages, and their potential impact on our portfolios.

Greece growing closer to default despite all the EU bailouts; another war looming in the Middle East; our own financial picture even worse than realized; continued mistrust of Wall Street: All of these “non-stories” will have market impact. It is remarkable how obvious the signs always seem in hindsight. These signs seem pretty obvious now, but too bad the media isn’t paying attention.

Chuck Osborne, CFA
Managing Director

~The Biggest News Stories Not in The News