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

Lots of people struggle with math. I am married to such a person, which helps me understand. To risk stating the obvious, I am not one of those people. Math always came easily to me, as it does for most people who grow up to be analysts and portfolio managers. Sometimes I need to be reminded that it is not the norm. One such occasion took place last summer.

We hired a 20-year veteran financial advisor and Certified Financial Planner (CFP) away from UBS. As I have explained numerous times this means he had 20 years of experience gathering and managing client relationships, which is what we have hired him to do, and zero experience making investment decisions. We sat him down and began to train him on our investment process and various models. We had barely begun when his eyes glazed over and he asked, “Where did you learn all of that math?”

Investing is almost all about math; specifically, understanding probabilities. For example, what would you say if someone asked you if the current market rally were going to continue? I know, it is our job to provide you with such prognostication, but I would guess most of you have a general feeling about this sort of thing. The market is off to a great start this year and we just had an excellent jobs report showing the economy added 243 thousand jobs in January, far better than expected. I would bet several would say the rally will continue.

What if I asked if you think it is reasonable for the market to be up approximately 70% this year? My guess is most would think that is not very probable with our slow economic growth. The funny thing is that those are actually the same question. If the market continues to go like it has thus far in 2012 it will end the year up 69.2%. I would love it, because in this mythical world our core equity strategy would be up 127.5%, but that is not going to happen.

I hate to be the one to pop the euphoric balloon, but trees don’t grow to the sky and markets don’t go up 70% in a year with 1.5-2.5% GDP growth, shrinking earnings growth, and geo-political uncertainty. We have all those things, and we are on pace for a 70% return; because that logically seems next to impossible, it becomes almost a certainty that we are headed for some sort of correction. It is just math.

The thing about math is that it can tell you what should happen, but it can’t tell you when or how it will happen. We could continue on for another month or two, or tomorrow could be the beginning of the downturn. We could drop dramatically and then rebound, or we may just remain flat for the rest of the year. Timing is an impossible task, which is why we believe it is wiser to be cautious, and to maintain higher than normal cash levels to help smooth the volatility. That is our plan.

Chuck Osborne, CFA
Managing Director

~It’s Just Math

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