The market is blowing up this morning and the question is, why? The answer is the same as always: Reckless speculators borrowed too much money against the wrong asset. Will they ever learn?

This time it is the yen carry trade. In plain English that means some speculators have borrowed money against the yen because Japan has some of the lowest interest rates in the world. They then use the money to speculate in stocks, which increases their returns dramatically, right up until the moment when it blows up and they lose everything.

Long-term readers will recall we wrote about this in 2008. At that moment it was mortgage-backed securities. It was the same in that massive borrowing led to the eventual collapse. That was more important because the asset people were borrowing against, mortgages, were more central to our economy and the speculators were big banks.

This appears to be more similar to the late 1990s when a hedge fund ironically named Long-Term Capital Management got over its skis with rubles (Russian currency). I lived through that one as well, but it was before we started Iron Capital. Long-Term Capital famously was staffed with a bunch of PhDs, who were living proof that there is zero correlation between intelligence and wisdom.

In that crisis we went through a short period of extreme volatility and then the market came roaring back. There are no guarantees in life, but I suspect the same thing will happen here. This has nothing to do with the real economy, which is still fine at this moment. Nothing in the real world has changed since we sent out last week’s Insight.

Periods like this are not fun, but for prudent investors they do create opportunities. We need to give this some time, but as the old saying goes, we want to be greedy when others are fearful, and fearful when others are greedy. In the meantime, we will do what we can to mitigate short-term damage. The most important thing is to remember that panic is never a wise strategy.

Warm regards,

Chuck Osborne, CFA
Managing Director

~Will They Ever Learn?

I have heard a lot of complaints this summer about the heat and humidity here in Atlanta. Every time I do and just laugh and wonder if they forgot what summer in Atlanta feels like? It is understandable as we have had multiple mild summers in a row, but this summer we are back to normal, which for Atlanta means 90 degrees, 90 percent humidity, and a thunderstorm every evening. This isn’t the best time of year to be in the ATL.

We seem to be getting back to normal in the markets as well. The old saying used to be that traders should “sell in May and go away.” That isn’t because summers are always negative, it is because summer is much nicer in the Hamptons than it is in Manhattan, not to mention Atlanta. The serious traders historically would take their profits in May and spend them on the beaches of Long Island, then return in time to get the kids back in school after Labor Day. As a result, volumes would go down during the summer and only the amateurs, and/or people who had no choice, would buy or sell any stocks. When that happens, we get strange nonsensical movements that most often correct themselves once the professionals return from summer vacation.

This summer that has meant the market has flip-flopped from the so-called Magnificent Seven stocks being the only thing working, to everything but the Magnificent Seven working. This bipolar action has been attributed to everything from Fed Policy to the presidential election. With Fed policy, the idea is that when the Fed lowers interest rates, if they actually do, then the economy will be stimulated and stocks other than the artificial intelligence (AI)-driven Magnificent Seven will rebound, especially small company stocks that are thought to be more sensitive to overall economic activity.

On the other hand, if it appears that the Fed may wait longer to lower rates, then the Magnificent Seven zoom ahead as they will grow with the AI movement and regardless of the overall economy. Similarly, there is a thought that another Trump administration would be good for economic growth while being bad for international trade, so smaller companies will do well while the big technology multinationals will be hurt by trade restrictions.

When President Biden dropped out of the race, the same people said, “Hold on.” Kamala would be good for the status quo, which would mean slower growth and more regulation. That means the big multinationals will be winners and the small companies will be losers.

Both sets of “experts” are fooled by randomness. As author Nassim Taleb pointed out in “Fooled by Randomness,” markets move randomly and then the professional pundit class searches for an explanation. Frankly, I don’t buy either of those explanations. I think it is as simple as we are finally having a normal summer.

In the meantime, prudent investors don’t try to trade anyway. We can enjoy our summertime, knowing what we own and why we own it. We are owners of companies not traders of stock, and the real world in which companies actually operate is doing pretty well. The initial reading for GDP for the second quarter came in at 2.8 percent. According to data from FactSet, with 41 percent of S&P 500 companies having reported their second quarter results, 78 percent have beaten estimates for earnings. The blended rate of growth of earnings, which includes actual earnings for those who have reported and estimates for those who have not, is 9.8 percent as of July 26. That is pretty solid growth.

Having said that, it is summertime and markets have been very strong year to date, but some short-term volatility should be expected and we might even get a short correction. There will be plenty of things for pundits to blame it on – elections, Fed policy, and global tensions all provide plenty of fodder for the pundit class. In the meantime, we should remember that prudent investing is done from the bottom-up. It is much easier to analyze the future of a specific company than it is to estimate the economic consequences of lower interest rates or one administration versus another.

Regardless of all of that noise, people will adopt AI. Smartphones will be purchased and used, as will groceries and clothes. People will still go on vacation, especially over the summer. Four years after the pandemic we continue to move closer and closer to normal. There are crowds at the Olympics, it is hot and humid in Atlanta, the Braves are already starting to choke down the stretch, and the market is being silly. Welcome back to normal.

Warm regards,

Chuck Osborne, CFA
Managing Director

~Return to Normalcy

I was on a roll. In the post-pandemic world, thus far Iron Capital has been spot on in terms of economic forecasts, and that is saying something considering how incredibly wrong most of Wall Street has been. The majority view has been that we are heading into a recession, and we have been consistent in saying that is wrong. When they had been wrong for an embarrassingly long time, they finally shifted to saying that we are headed for a “soft landing.”

A “soft landing” means that the economy will slow, maybe even stall, but avoid an actual recession. The description is often put forward by the press as something the Fed is trying to accomplish. The image they paint is the economy as an airplane and the Fed is the pilot. It is a very bad analogy; the Fed does not control the economy and neither does Congress or the president. I can still remember my college micro-economics professor stating boldly that the economy is more powerful than any government. I didn’t understand what he meant at the time, but I do now.

The economy is nothing more or less than the cumulative financial behavior of all the citizens put together. Regardless of government policy we are going to buy groceries, houses, cars, computers etc. This is not to say that policy doesn’t have an influence at the margins: We will spend more when we get to keep more of our income, we will start more new companies when regulations make it easier to start a new company, and we may buy a bigger house if interest rates are lower. These things do impact the margins. However, the main driver of the economy is its natural cycle.

Where most pundits went wrong is that they refuse to admit the reality of the recession of 2022. We had a recession is 2022, just two years after the self-induced recession of 2020. Therefore, we have been in the recovery phase of the economic cycle, which is as far from recession as one can get. It has been muted as recoveries go, due to the shallowness of the recession itself and really bad fiscal policy partnered with relatively restrictive monetary policy.

This explains why we have been right while so many others have been wrong. When the initial reading of first quarter GDP came in at 1.6 percent, I said we were still on course. I told several clients I would wager that the revisions of GDP would come in higher. I was wrong. The first revision came in at 1.3 percent. In addition, the Atlanta Fed’s GDPNow measure of real time GDP has dropped from more than 3 percent growth to 1.8 percent on June 3. We are still growing, but growth is slowing.

Is that enough to alter our outlook? Not yet, but it cannot be ignored, and it is concerning. We must be willing to change course if the data requires. This leads to the other problem with Wall Street pundits: The vast majority make up their minds as to what will happen and then look for data to support that conclusion. Thus, many well-paid Wall Street pundits live by the broken-watch-is-right-twice-a-day rule. If they just keep saying the same thing, then eventually they will be correct.

Jamie Diamond, CEO of JP Morgan, is one of the best bank CEOs in the world. He is very good at his job. I can’t tell you if he has made any economic predictions lately, but I can tell you that if he has, it was all gloom and doom. His cautious nature makes him exactly what one would want in a banker, but a really bad economic forecaster.

I have not read Fundstrat’s Tom Lee’s latest report, but I can guarantee it is bullish. How do I know? Because Lee is always bullish, and he continues in a long and distinguished line of Wall Street strategists who are permanently bullish.

The broken watch philosophy works for one’s career; those who are always bullish have the advantage of being correct the vast majority of the time, as markets generally go up. Those who are permanently bearish have the advantage of being right at the most impactful times, as losses impact us psychologically far greater than gains. How many times have you seen someone brag about predicting the last X number of market selloffs? They just don’t mention the hundreds of selloffs they predicted that didn’t happen.

We try to do things differently here. We try to be correct, and that means we have to admit when we are wrong so that we know when it is time to change our minds. It also means knowing oneself. I am naturally optimistic, so I continually remind myself to be cautious, and that starts with accepting the data instead of explaining it away. We have seen a slowdown in growth, and caution is in order.

Warm regards,

Chuck Osborne, CFA
Managing Director

~I Was Wrong

“I don’t see the stag or the flation.” ~ Fed Chair Jerome Powell, May 1, 2024

The initial reading for first quarter 2024 GDP came in at 1.6 percent growth, lower than expected and much lower than the 3.4 percent seen in the fourth quarter of 2023. Inflation readings have come in above expectations, leading a few pundits lately to claim that we are heading for “stagflation.”

Stagflation was a term first used in Britain by Iain Macleod in a 1965 speech before the House of Commons. Most Americans attribute it to Jimmy Carter, whose administration brought us a combination of double-digit unemployment with very high inflation and negative GDP growth. In short, stagflation is an economic term that represents the worst of all combinations.

What caused it? Stagflation is a combination of bad outcomes and likewise doesn’t have one single cause, but instead arises from a confluence of poor economic policies. The list of policy mistakes includes deficit spending, over regulating, and overly progressive taxation, accompanied by high levels of unionization.

Deficit spending stimulates demand in the economy. Regulation and taxes constrain supply. High demand and constrained supply give us inflation. Inflation became embedded in 1960s Britain and 1970s USA because unions pushed for higher wages to offset the sting of inflation. This makes sense on the surface, but the problem is, one cannot get blood out of a turnip. The money for those raises wasn’t there, so companies had to reduce the workforce to pay higher wages to those who remained. This may sound controversial today, but at the time, union leaders openly admitted this was their goal. That drove up unemployment and further constrained supply, which made inflation worse, creating a reinforcing feedback loop.

Before I’m accused of being political, note that much of this bad policy in the U.S. came from the Nixon administration, and the reversal of this destructive path began under Carter. It is also important to note that many of these things were being tried for the first time, so leaders of the day did not know the consequences as we do – or rather, should – today.

If this stew of poor policy sounds familiar, it is because we are heading down the same path currently. This track, along with the GDP and inflation data, are leading some to claim that stagflation is back. Is it?

No, we are not experiencing stagflation today. As Jay Powell brilliantly pointed out in his post-Fed decision press conference, “I don’t see the stag or the flation.” First the “stag”: Our economy is still growing. Yes, the 1.6 percent headline is disappointing, but we need to look under the hood. The slowdown relative to the fourth quarter was driven by a slowdown in consumer spending, exports, and government spending. Imports increased, which are actually a negative for the GDP calculation, but not for the economy in reality. The economy must be strong for consumers to be able to purchase foreign goods.

The slowdown in consumer spending was on goods, while services actually increased. So, services increased, and imports increased; that hardly reflects a weak consumer. We must also remember that this is only the first reading. It will get revised, and I would wager the revision will be higher. GDPNow, the real-time GDP calculation provided by the Atlanta Fed, finished last quarter over 2 percent. It has been very close to the final reading, which it should be as it is purely based on the data with no assumptions. Currently it says we are growing at 3.3 percent. It is early and that will likely drop as more data comes in this quarter, but it is still solid growth. The economy is not stagnating.

How about inflation, or as Powell said, the “flation”? The readings have been higher of late, but as we have noted, this is in line with what should have been realistic expectations. Once inflation got down to 3 percent, that last 1 percent the Fed wants is going to take time, and month-to-month data will be lumpy. Powell stated that their read of inflation is that it is just under 3 percent, which is in line with the year-over-year readings for the Fed’s preferred measure, Personal Consumption Expenditures (PCE). That isn’t the 2 percent target, but it isn’t 2022 levels of inflation, let alone the 1970s.

Meanwhile, corporate earnings are coming in strong for this quarter. In the long run that is what drives stock prices. Unemployment remains low and the labor market remains tight. This doesn’t mean that we should not be concerned about the deficit spending and the current regulatory onslaught, as these things can absolutely cause damage over the long term. However, we should not participate in the culture of hyperbole. We will let our yes be yes and our no be no. There is no stagflation today and to suggest otherwise is simply an attempt to be bold and grab attention. That may work for social media, but it doesn’t work for investment results. We will focus on the latter.

Warm regards,

Chuck Osborne, CFA
Managing Director

~Stagflation?

Inflation is back in the news: The latest reading of the consumer price index (CPI) came in at 3.5 percent. Does this mean all is lost in the Fed’s fight and it is time to sell everything? No, of course not.

The worry on Wall Street is that higher inflation means that interest rates will go higher, which will drive stock prices down. We have made two statements in our Research and Commentary over the past year that still hold true: The first is that it should surprise no one that the last 1 percent of inflation will be the most stubborn. This rise from 3.2 percent to 3.5 percent does not mean that the battle is lost and the Fed must keep rates higher. Nothing in nature goes in a straight line, and inflation will always vary from month to month.

The other observation we have noted is that interest rates, and oil prices for that matter, are simply trading in a range. We were near the lows of that range when I wrote that, and sure enough, we are now heading to the top of the range. Interest rates on the 10-year Treasury are trading around 4 percent. They have gone as low as 3.8 percent and as high as 5 percent, and now are near 4.5 percent; this is closer to the top of the range, and they will likely head back down closer to 4 percent once more. Could they break out of the range and keep rising? Anything is possible, but it is not likely. As of now, nothing has really changed. We remain in a range.

The same is true for oil. I said that oil was in a range between $70 and $90. When I noted that, oil was going down and was near $71. It is now going up and near $85. It is still in the range. Nothing has really changed.

Stocks have sold off on this data and of course the pundits are predicting doom as per usual. The truth is that the market has come a long way over the last six months, and it would not be surprising at all to see a step backwards before going forward once more. This is how the market works. It does not go in a straight line; the trends, however, remain strongly upward.

Can that continue if the Fed does not cut rates? Of course it can. The truth is that the economic data shows we do not need a rate cut. The economy continues to be resilient. The Atlanta Fed’s GDPNow reading shows the economy growing at 2.4 percent as of April 10. This means that corporations as a whole should be growing earnings, and it is earnings that drive stock prices, not interest rates.

I have said it many times, but when it comes to the real economy, the power of the Fed seems to be greatly exaggerated. This won’t stop Wall Street traders from fixating on Fed policy, as it certainly has an impact on markets in the short term. Longer term investors, however, can rest assured that it is the real-world results from the companies themselves that drive long-term stock prices.

We may get a correction if the Fed decides not to lower rates in June, but corrections are normal. Nothing goes in a straight line – not inflation, not oil prices, not interest rates, and certainly not stock prices. We are still on course.

Warm regards,

Chuck Osborne, CFA
Managing Director

~Still on Course