The third quarter of 2011 was the worst quarter for investors since 2008. You are going to hear that scary phrase a lot, so brace yourself. This is one of those times when I would like to swoop in with all kinds of good news and prove that things are not as bad as they seem. There are silver linings: stock valuations are the best they have been in a generation. Corporate results have been strong and their stocks are selling at bargain-basement prices. This most probably will prove to have been a great time to be buying stocks when we look back a decade from now. It sure does not feel that way now, and most likely it won’t in the near future.

We have spoken frequently this year about the dichotomy between the bottom-up attractiveness of so many equity investments, and the top-down gloom of our geo-political situation and the overall economic malaise this situation has delivered. In third quarter it was the latter that dominated the stage, and as a result we have seen a rapid drop in equity values.

The headline-grabbing Dow Jones Industrial Average was down 11.49 percent while the often-quoted S&P 500 was down 13.87 percent. Unfortunately these popular benchmarks paint a rosy picture on what really happened: small-cap stocks were down 21.87 percent while German stocks were down 25.41 percent and Hong Kong saw a 28.99 percent drop.

All of this is most likely an overreaction to a global economic situation that is probably better than most believe. Unfortunately, this overreaction can become a self-fulfilling prophecy. The volatility of the market itself can cause pessimism, and pessimism can cause a recession. The odds of slipping back into recession have increased significantly; today I would give it a 50-50 probability. Three months ago I thought the odds were slim.

Even if the U.S. manages technically to avoid a recession, we are still back at one to two percent GDP growth, which may be a distinction without difference. To us at Iron Capital this means the odds of continued downturn are significant. Let me say it again: it is time to brace yourself. Now is the time to be honest about how much risk you are willing to take. For some of you third quarter alone has gotten you to that point, while for others it will take more pain. Now is the time to make those decisions, not after the recession is here and the market is down another 20 percent.

Investing is not complicated. It is no more complicated than losing weight. In the latter you simply have to eat less and exercise more, and in the former you simply have to buy undervalued securities and wait until their value is recognized. These are not complicated things to do, but they are among the most difficult challenges we all face.

We are here to help. We are doing what we can to protect in the short-term while remaining focused on the long-term. Today that means we are bracing ourselves.

Chuck Osborne, CFA
Managing Director

~Brace Yourself

John Maynard Keynes is known by most as a famous economist whose creative ideas on smoothing out the rough edges of the business cycle have proven repeatedly not to work. However, during his life he was also a money manager and one of the greatest of all time. His ideas on investing have influenced many, and some would argue that he invented the concept of the hedge fund. I tell you this because regardless of your thoughts about his economic ideas, I believe his thoughts regarding the market are worthwhile.

One of my favorite Keynes quotes goes as follows, “Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.”

It certainly feels like Keynes’ prophetic warning has come to pass.

The public markets have become hostages to so-called high-frequency trading (HFT) firms. These are organizations that trade stocks through computer programs at a rate of speed not before fathomed. It is literally possible for these firms to “own” a stock for no more than a few seconds. This is speculation run amok and they are harming our market, and as a result the allocation of capital in our society, and ultimately job creation and the economy as a whole. They need to be stopped.

It is important to understand why this is such a problem today. The stock market has always been home to a certain number of speculators; today they like to be called traders, but I prefer the more accurate title along with the deserved negative baggage. Having said that, speculators do serve a purpose, and they will always remind you of this. They provide liquidity. Long-term investors can buy and sell when they wish largely because there is always some short-term speculator willing to be on the other side of a transaction. Speculators can even provide opportunities for investors as they create dislocations in the market, beating up stocks to the point where they present great long-term opportunities for gain. Besides, speculating can be fun. We all have a little speculator in us. This is part of the lure of Wall Street to so many young professionals. (Experience usually takes away some of that luster; after all, Las Vegas was not built on gamblers’ ability to win.)

Historically, and not that long ago, speculators were held in check because theoretical profits of various rapid-trading strategies were destroyed in reality by taxes and transaction costs. This has changed. The automation of trading has made it so cheap that small profits can be made holding stocks for seconds. What this has done is ramp up the volatility to places I have never seen in my career. Much of it is just stupid.

One recent example can be found in the stock of Express Scripts. Express Scripts is a pharmaceutical benefits company – the people who pay for your prescription drugs. A well-known analyst lowered his price target on Express Scripts from $64 to $60, and the stock went down almost three percent that day. On the surface this may make sense – an analyst lowering the price target is not a good thing. However, the intrinsic fact being ignored is that Express Scripts was trading at approximately $43 when this announcement was made, so the analyst believes the stock is going to go up almost 50 percent. No human being would see that message as bad, but to a computer program that operates by a rule – analyst lowers target = sell – that is a different story. During the extremely volatile week of August 8, an estimated 80 percent of market volume was attributed to computer trading. The flash crash of last May was attributed to the same issues.

This volatility is keeping real investors out of the market. In fact I believe the old argument for speculators creating liquidity has fallen apart. By keeping investors away these HFT firms are actually destroying liquidity. Total volumes in the market are still below their 2007 highs.

The SEC is trying to do something about it. They are creating a trading auditing system named CAT that will help them monitor the actions of these HFT firms. The firms are pushing back. I don’t know if this auditing system will be the answer but it certainly will help. The added cost in trading alone will slow these firms down.

I have a better solution. Most of the money that floats around on our exchanges actually belongs to institutional investors – pension plans, endowments, foundations, and your retirement accounts. This money is all tax-exempt. In addition, hedge funds that consider themselves traders and not investors are given tax advantages. The bottom line is much of this extreme short-term speculation goes on because none of the practitioners have to factor in taxes. This means it makes no difference to them if their profits are from short-term trading or long-term investing. My suggestion is to take away the tax exemption for short-term capital gains for otherwise tax-exempt institutions. It wouldn’t take a week for every institutional investor in the country to pull every dime they have given to the short-term trading firms.

I am a big believer in free markets. It is usually the rules, not the freedom, that cause problems. In this case the rules – tax exemptions and tax breaks – have actually unintentionally encouraged speculation over investment. It is time to correct that. Creating an audit trail and/or paying a tax will not eliminate speculation, nor should it. It may, however, put it back in its place, as the bubble on the steady stream of enterprise.

The rapid-trading firms are a small, cohesive group with a lot of money, which gives them a great political advantage over the masses of investors who would benefit from their being constrained. I urge each and every recipient of this message to reach out to their elected officials and tell them you wish to encourage investment and discourage speculation. Remind them that capitalism is not about trading, it is about capital flowing to real companies that produce real products and in so doing, create real jobs.

Chuck Osborne, CFA
Managing Director

~A Hidden Menace

Our world, and by extension the investment markets that are a reflection of our world, seems to be suffering from a serious case of over-specialization. The advice most often given to the last generation of workers and professionals was to learn all one could about one thing. Become an expert in your field. This is logical advice, but, like anything in life, when taken too far can cause problems. In becoming experts on singular issues we seem to have lost focus on the big picture. What we need in our world today is what they used to call a “Renaissance Man,” someone who was truly educated and knew about a great many things. Someone who can see the forest and not just the trees.

What does this have to do with our current investing environment? Everything. It seems we live in a world where investors and policy-makers alike do not seem to understand the consequences of their actions on other parts of the world. Our world is one big living organism, it is not a series of specialized silos. The only way to see the truth – the whole truth – is to understand the big picture.

Last week the federal government announced that it was suing the 17 largest banks for “their part” in the financial crisis. Today there is an article in The Wall Street Journal suggesting that one of the largest obstacles to a robust recovery is the inability of so many homeowners to refinance and actually take advantage of these historically low interest rates. In our specialized world people seem to read these as two unrelated items, yet they are not: a bank being sued for being too aggressive in their lending practices is going to react by not lending.

Investors are acting just as recklessly. A few weeks ago I received a newsletter from one of our competitors in which they were claiming that inflation was coming, justifying their large allocation to commodity investments. They, along with so many others like them, caused a spike in commodity prices. When that happens in an environment that is not inflationary – as we discussed in our latest “Quarterly Report” – it leads to an economic slowdown. Friday I received another newsletter from the same firm saying that we are heading for a Japanese-type stagnation; however, there was no admission of their role in causing such by artificially boosting commodity prices.

Nowhere is this dangerous lack of focus on the big picture more disturbing than in Europe. Every time the EU tries to solve a debt crisis fire with a band aid, simply kicking the can down the road, the bigger the next fire becomes. The EU needs to take decisive action one way or another to bring this crisis to an end. Allow Greece to exit the EU and default on their debt, or take their debt over completely. Until then we are going to continue to see market turmoil. European markets are down approximately eight percent over the last two days.

The markets will be watching the President’s speech on jobs this week. Hopefully there is a realization that all actions of government affect jobs. Health care, financial reform, wars, tax reform and the debt crisis – these are not isolated issues, one different than the other. They are all parts of the bigger picture, one that has been incredibly bad for jobs and that increasingly is risking a new recession.

Another part of that big picture is the actual health of the corporate world. Corporations are not lowering their forecasts. In August only 138 companies lowered their earnings forecasts, while the norm over the last decade has been an average of 221 lowering forecasts. If you split the world into three segments, governments, consumers and corporations, corporations are in the best shape by far. Unfortunately, the market is ignoring this third of the forest, even though it is the third where your money is actually invested.

This leads to a frustrating environment where the opportunities for future returns look very attractive, but the immediate concerns over government balance sheets and the hard politics that go along with this situation increasingly are causing the consumer to grow pessimistic. The end result is volatility. The longer this volatility lasts, the greater the probability of a severe bear market.

I am not saying this is a foregone conclusion; in fact we remain cautiously optimistic over the next two to three years, but the odds of a severe bear market are increasing. What we need is some well-rounded, big-picture leadership from policy-makers who consider the whole truth. Unfortunately we seem to be surrounded by specialists. Alas we must play the cards we are dealt. We will continue doing all we can to protect your assets in this environment.

Chuck Osborne, CFA
Managing Director

~The Truth, the Whole Truth, and Nothing but the Truth

Volatility is back in a big way. Since the downgrade of U.S. debt by S&P, the equity markets have been swinging wildly. There is a sense over the last few days that we have finally gotten past all of this as positive momentum has taken over, but I’m not so sure.

We are investing in the midst of a split reality. On one side you have governments throughout the developed world that have spent beyond their means. It is easy to make promises when times are good and you are running for re-election. Who doesn’t want their retirement funded, or healthcare provided? Who doesn’t want their taxes reduced or homes subsidized? All of this is easy until the bills come due.

The bills have arrived for Greece, Italy, and the rest of southern Europe. This has highlighted the fact that our bill is on the way, and it is going to be a doozie. Our politicians seem more divided and partisan than ever, people are anxious, and S&P says the U.S. Treasury bill is more risky than the mortgage-backed securities that started this whole mess almost four years ago.

However, on the other side of this split reality we have corporate America. Here most things are actually good. Every quarter it seems that corporations report better earnings than expected. Revenue has been growing year-over-year. Balance sheets are strong and the prices are right for long-term investors.

So it’s really just a matter of on what one wishes to focus: If we focus on fundamentals of the companies in which we are investing, the market is up three to four percent that day. If we focus on our national debt and our political environment, the market is down three to four percent that day. This volatility is why we have taken steps to reduce the risk in our portfolios, while simultaneously looking for opportunities.

This environment is stressful, and unfortunately it is not over. It probably will not end until the debt crisis is actually addressed. Thus far in most of the developed world, politicians have played kick the can: they apply one Band-Aid after another, thinking that if they can just postpone the inevitable for a few more months things will get better. That is wishful thinking.

In Europe the EU needs to do one of two things: get weaker, by allowing the troubled countries to get out and fix their own mess; or get stronger, by issuing Euro bonds and taking over the debt of troubled economies. Today I believe the latter to be the highest probability. The longer they wait to end this crisis by taking one of those radical steps, the longer we will be on this rollercoaster.

Domestically, we need a coherent direction. We all have our own political feelings and opinions on what that direction should be, but in terms of investing, which direction isn’t as important as having a direction – any direction. We now seem rudderless.

The story goes that Mark Twain and novelist William Dean Howells stepped outside one morning, a downpour began, and Howells asked Twain, “Do you think it will stop?” Twain answered, “It always has.” It may take a while, but this malaise will pass. When it does, investors should once again focus on the actual investments. When that happens we should be ready for a long bull run.

Chuck Osborne, CFA
Managing Director

~This Isn’t Over Yet

Standard & Poor’s (S&P) has downgraded U.S. Treasuries to AA+ from AAA. While this has been discussed for several months, the announcement yesterday evening came as a bit of a surprise.

The question is, what does this mean for you? The truth is that I am not really sure, and neither is anyone else, regardless of how confident they may sound about their theory. This has never happened in the U.S. and no one really knows exactly what is going to happen. I can tell you that Iron Capital’s investment committee is going to meet via teleconference Sunday evening and again very early on Monday morning. We will determine what, if any, action is appropriate and be ready to act when markets open.

In the interim I can shed some light into the real issues at hand here. Let me start by reminding everyone that credit rating agencies’ opinions are exactly that, opinions – nothing more, nothing less. S&P has just announced that it is their opinion that U.S. Treasuries are not as safe as they once were. We have been announcing that opinion for two years now. Someone stating their opinion does not actually change reality. The U.S. government is not more likely to default on their debt today then they were yesterday, before the downgrade. Unfortunately, while downgrades don’t change reality, they can shift the perception of reality, and that may be more important.

The textbook response to a downgrade would be a sell-off in the bond market as people sold the downgraded securities, which would result in higher interest rates. Undoubtedly you will be hearing about the dangers of higher interest rates from media talking heads. This is certainly a possibility; however, recent bond market behavior would indicate that this is not likely. On June 30, the ten-year Treasury had a yield of 3.22 percent. At yesterday’s close that yield was down to 2.56 percent. That lower yield means a higher price, and that means investors have been buying Treasuries like they are going to stop printing them. This has happened while the biggest financial story of the last month has been the debt ceiling and the possible default and downgrade of Treasuries.

You all should know this, as I have been writing ad nauseum about the irrational behavior of the bond market. If the threat of default didn’t make interest rates rise, a downgrade may not either. In fact, Japan has been downgraded regularly over the last decade and a half or so, and they still have very low interest rates. However, there is a danger that some institutional investors may have to sell.

One of the biggest problems in the institutional investment world is rules-based investing. Too many plan sponsors think they can protect themselves from poor judgment by replacing judgment with rules. Nowhere is that more prevalent than in the investing of bond portfolios. Several states have even gone so far as to legislate rules into the state code for public pensions. This was a major contributor to the financial crisis and one that has not been addressed. Many pension plans will be forced to sell Treasuries, even though they may not want to, unless they can get these rules changed.

The credit rating agencies should have never been given that much power. Their ratings are no more meaningful than the buy or sell ratings of Wall Street analysts in the equity world, as was evidenced by the AAA rating of mortgage-backed securities. No one would ever write an investment policy that limited equity portfolio managers to stocks that had buy ratings, yet the industry does it all the time in the world of bonds. This practice needs to stop, and investors need to use their own judgment and conduct their own research. All the bond managers we use and recommend already do this.

There is probably time to get these rules changed as S&P is only one rating agency and the rules don’t usually state which rating agency the investors have to use. The selling may be less than expected because Moody’s and others still have the U.S. at AAA. However, since S&P has downgraded, the others will likely follow soon. If these rules can be changed, then drastically higher interest rates and a route in the bond market may be avoided.

Theory would also suggest no reaction in the stock market as this downgrade does not directly impact stocks. However, the stock market tends to be emotional and it is already at a low ebb. Some think the downgrade is already priced in, while others are sounding alarm bells. Either way, this is short-term. It has the potential to turn this correction into a bear market, or it could be nothing, but it will be the fundamentals of the actual companies – not the U.S. Treasury – that determine the long-run results in the stock market.

We know that news like this is scary. The media only make it worse, since they don’t want you to turn the channel. The first step in scary situations is to not panic, and I can assure you we will not do so. We are on top of the situation and will take defensive measures if necessary.

Chuck Osborne, CFA
Managing Director

~S&P Downgrades U.S. Treasuries: Now What?