I’m not sure how it happened, but someone has caused a rally in the bond market. Commodity prices have been dropping, although not as fast as they should. Stock prices have been falling faster than they should, and bonds are rallying.

The yield on the ten-year Treasury has dropped from 3.5 percent to just below three percent. For those who need a refresher, bond prices move in the opposite direction of interest rates, so a drop in the yield equals an increase in the price. To understand the oddity here one must put all of this in context.

The Federal Reserve has been buying up Treasuries in a program commonly referred to as QE2. Some have estimated that the Fed’s purchases represent as much as 30 percent of current demand for Treasuries. This program is about to end. Economically if the largest purchaser of Treasuries stops buying, the price should go down, not up.

Down the street from the Fed our representatives in Congress are debating whether to raise the debt ceiling. Treasury Secretary Tim Geithner has told us that if this does not occur then all these Treasuries will be in default and the world will actually come to an end on August 2, not October 21 as that other guy predicts.

Moody’s is threatening a downgrade of Treasuries. Bill Gross, the man who manages more bond assets than anyone else in the world, has very publically taken a short position in Treasuries. Yet, the Treasury market rallies?

I can understand the market ignoring Geithner’s warning of sudden doom on August 2. I don’t believe anyone seriously believes that Congress will not raise the debt ceiling. In the interim we are witness to a lot of political theater and some smaller amount of actual negotiation between the Administration and Congress. However, does anyone not think QE2 is going to end? Does no one care that the world’s preeminent bond man is going short and one of the largest rating agencies is considering a downgrade?

The bond market’s answer? “No.” It doesn’t care. How can this be? We have been pondering this question for weeks now, and have come up with only one somewhat satisfactory answer: old habits die hard.

Shortly after the earth cooled and mankind started walking on it, that talking baby in the E-Trade commercials and his trading friends invented the ‘risk-on risk-off trade.’ We see it everywhere. The simple version is evidenced in almost every individual portfolio I have ever seen (before it comes to Iron Capital, that is), made up of nothing but equities and cash. The self-proclaimed “savvy” investor usually talks about going into and out of “the market” – a statement which is evidence enough of a lack of actual savviness. The professional version of the same disease is the rotation between Treasuries and anything else that isn’t a Treasury.

In other words, the only explanation we can come up with for the piling into Treasuries is that, with all their current faults, Treasuries are still the safe haven for temporarily parking money when you don’t know what else to do.

The unfortunate part in this knee-jerk reaction is that safety in investing is not, as some believe, a permanent design feature. The ‘stocks are risky and Treasuries are safe’ mentality is naïve to say the least. Let’s not forget that it was the mortgage-backed securities with their quasi-government backing making them “almost as safe as Treasuries,” which caused the market meltdown of 2008. Safety is not a function of product design; it is a function of price compared to actual value. In that light, Treasuries are not looking so safe today.

There are those who disagree with this position and will claim that the risk to principal is overstated. I believe they are missing the point. We often repeat the quotation from Benjamin Graham that a sound investment offers safety of principal and an adequate return. As I write, the 10-year Treasury offers a return of 3.125 percent. Even if we are wrong about the risk to principal, I don’t know many who would call that an adequate return. Graham says the purchase of securities which fail his test – any part of his test – is not investing but speculation, and that is exactly what the risk-on risk-off traders are doing.

Chuck Osborne, CFA
Managing Director

~Old Habits Die Hard

It is always hard to tell when a market has gone from being just a little maddening to becoming a full-blown bubble, but we are starting to see some telltale signs.

One of those signs is the classic market bifurcation. Over the last year, everyone has done well on an absolute basis but some have done much better than others. Over the twelve month period ending March 31, 2011, the Russell 1000 was up 16.69 percent, but the Russell 2000 was up 25.79 percent. At quarter-end the Russell 1000 had a P/E Ratio of 17.2, compared to the Russell 2000 P/E Ratio of 29.9. The out-performance of small-cap stocks cannot continue with that big of a P/E dispersion, or so one would think.

Commodities are up even more, many over 100 percent. Last quarter the energy sector in the S&P was up 16.8 percent. Gold, which was ridiculously priced at $1,000 per ounce, is now $1,500 per ounce. Silver is through the roof as are less sexy commodities like cotton. These are all supposedly hedges on inflation, yet the only inflation the eye can see is the commodities themselves. Wages are not growing. GDP growth is low, so where is the actual inflation? There is a great deal of talk about inflation because of food and fuel costs, but economically inflation means the cost of everything rises. Inflation occurs when prices rise and people pay those higher prices through a combination of higher wages and increased debt. In true inflation you must have more money to spend, and we don’t have that today. There is next to no wage pressure and consumers are not borrowing money; if anything, it is the opposite. Today what we see is prices rising in specific areas and people adjusting by spending less elsewhere.

The overall market return is not surprising as much as what is actually driving the market: momentum. Things that have been going up keep going up. When momentum gets carried away and assets that seem overvalued continue to rise while simultaneously assets that seem reasonably valued are ignored, it starts to look and smell like a bubble. The last thing that happens in a bubble is that the really smart money managers, the ones who care about things like fundamental valuations, start to underperform. This is happening. These are signs.

There are also signs that the bubble may be bursting. Commodities have come under pressure. Most notably silver is down nearly 30 percent, but it is hardly alone. Yesterday a host of poor manufacturing reports from around the globe contributed to the commodity downfall. Small cap stocks are already in the red over the last four weeks and large caps may well join them.

My hope is this is just the beginning of a market correction followed by a rotation into more sound areas of the market. Yet my fear is…here we go again!

Chuck Osborne, CFA
Managing Director

~Commodity Bubble?

Over the years I have written a great deal about the various problems in my industry. I have discussed the flawed structure of the retail brokerage world, the lack of training of the vast majority of “financial advisers,” the layers and layers of fees, and the conflicts of interest. I also have discussed the psychological mistakes investors make – the desire to fit in, which leads to following the crowd into asset bubbles, and in some cases scams; the desire to not admit mistakes, which leads to holding on to losers far too long; and the overconfidence in investing in areas where one feels comfortable, which leads to under-diversification and the taking of undo risk. I have written about all of these issues and more.

However, not until this week had I seen evidence of how much these phenomena collide. Somehow I got on an email list for an industry newsletter called, originally enough, “Investment News.” Usually its content is nothing but garbage, but this week a title caught my attention: “Advisers Not Charging Enough.” The article was based on a study by a software firm PriceMetrix Inc., which provides practice management software to the adviser community. They studied the fee arrangements of fee-based financial advisers and found that there does not seem to be any rhyme or reason to the fees charged.

PriceMetrix said that finding was their biggest surprise, but that is not a surprise to me. What was surprising – in fact shocking – to me was a statement made by Doug Trott, CEO of PriceMatrix, who said, “Those advisers doing the most business tended to charge more.” He went on to discuss the difficulty advisers have in raising their fees, and here was another shocker: the advisers who were successful at raising their fees were the ones who charged more than average from the start. An even bigger surprise: advisers who raised fees opened 25% more new accounts than advisers who lowered fees. Mr. Trott’s advice to advisers, “The message from the data is that advisers should charge more.”

Relax. Iron Capital is not about to take Mr. Trott’s advice. We have set our fees based on the hurdle rate we believe we can get over to achieve our goal of providing you with market-beating investment results over full market cycles. Nothing kills returns like fees, yet the retail investor still seems to be blind to them.

It has always been shocking to me how people choose an adviser. We have been very fortunate at Iron Capital in that we are the largest fee-only adviser in Atlanta even though the other firms in the top-ten have been around a lot longer. Still, if one were to ask me about the hardest part of my job, I would say it is getting new clients. I have always been amazed at how people like Bernie Madoff were able to gather so many assets running a scam. Yet it is not just the Bernie Madoff’s of the world. I have recently been talking to some people interested in joining Iron Capital. Their firm has fallen apart, largely because one member of the firm put several of his clients into a ponzi scheme. The people to whom I’m talking had nothing to do with it, but you know the old saying about one bad apple. What is amazing is that the bad apple also was the biggest producer in that firm. The nicest, most honest guy in the firm? You are correct, he was the smallest producer.

People make financial decisions for all the wrong reasons. One of our biggest competitors in Atlanta begins every sales pitch by telling prospective clients who their biggest client is, and he is a famous, very successful businessman. Of course, no one should ever make an investment decision based on what someone else has done, but it happens all the time. An important side note here: Iron Capital considers our private clients private, and not only because selectively disclosing client names is against SEC regulations, but also because it also goes against the trust our clients have placed in us.

Investors should look for an adviser based on several important criteria:
• Background – have they ever managed money? The vast majority have not.
• The structure of their business – true independence and a fiduciary relationship.
• Their investment philosophy – does it match yours?
• Their track record of success across all of their clients, not just one star client.

Investors also should pay attention to the total cost of their portfolio. Based on what we have seen in competition, Iron Capital’s total cost is much less than anyone else we have encountered. This is not because we desire to be a low-cost leader or some kind of discount operation. Exactly the opposite is true; our service is greatly differentiated. Our cost structure is this way because our goal has never been to impress, or to gather the most assets, or to make more money than our overpaid competitors. Our goal always has been to deliver the best investment results, and if that is your goal, you try to keep investment costs to a minimum.

Some days I feel ashamed of our industry. Mr. Trott’s findings were bad enough, but to react by saying advisers should just go along and raise their fees because they can, taking advantage of irrational consumer behavior, is truly disappointing. I have a better suggestion: Let’s try to educate the consumer, not take advantage of them.

Chuck Osborne, CFA
Managing Director

~Irrational Investor Behavior

First and foremost let me say that our thoughts and prayers are with the people of Japan who continue to suffer in this awful tragedy. I know I have shared this story with many of you before, but any time my job forces me to focus on what is often the cold, hard reality of looking after our clients’ money during times that reminds us there are far more important things, it brings me back to those days after 9/11. I was with Invesco and I had to call fund families in New York with whom we did business to find out first, if they were alive, and second, whether they would be able to do business when the markets re-opened. It was not fun, but it was necessary. Even at times like this we have to remember that our first responsibility is to you, our clients.

So, let me cut to the chase: we had practically no exposure to Japan in any of our clients’ portfolios. We have had a sizable underweight to developed international, which is basically Japan and Europe, and within that space we had an underweight to Japan.

Having said that, we are not surprised to see the overall market react negatively to what is happening in Japan. We are also not concerned at the moment. There is a great scene in Disney’s “Pirates of the Caribbean,” when young Will Turner asks Mr. Gibbs about the story of Capitan Jack Sparrow. Mr. Gibbs talks about Jack being left behind on a deserted island and Will asserts that this must be the reason for Jack’s odd behavior. Mr. Gibbs responds, “Reason’s got nothing to do with it.”

There is a lot of investing wisdom there. Natural disasters often bring about market sell-offs and there is seldom an actual good reason for it. Business in Japan has certainly been disrupted, but the disruption is temporary. It is possible that insurance companies may be hurt with large claims, although JP Morgan this week in a letter to clients estimates that the losses will be handled easily. It is probable that Japan may need to import more coal until they can get their nuclear power plants operating safely again, but this is a temporary blip.

The truth is that Japan was an economic mess before this happened. They are still suffering from a deflationary spiral that has been going on sporadically for nearly three decades now. They are a net exporter to the world and consume relatively little, so the business disruption for US companies is not likely to be great. Even the largest Japanese companies like Toyota now manufacture in multiple locations including the US. Once the dust settles and they have the nuclear issues locked down, a rebuilding process will begin. That process actually will be stimulative to their economy.

In the meantime this tragedy occurs on the tail end of a strong six-plus month run for the stock market. Traders have been warning for a pullback but it just hasn’t happened. Is Japan a good reason for the market to fall? Well as Mr. Gibbs knows, “reason’s got nothing do with it.” Excuse, maybe; reason, no. Ultimately financial markets are about two things, prices and earnings. It is hard to see any real earnings disruption for non-Japanese companies, so any price reduction will just makes the market that much more attractive.

Of course we will be diligent should something change, but it looks like the market is progressing as we thought it would in 2011, three steps forward and two steps back.

Chuck Osborne, CFA
Managing Director

~Japan, Natural Disasters and the Stock Market

This may come as a surprise to some of our clients, but Iron Capital does not have a monopoly on economic or market insight (wink, wink). There are a lot of very smart people in our industry, and Wednesday night we had the honor of hearing from two of them. So I thought we would share what others think for a change.

The occasion Wednesday evening was the CFA Society of Atlanta’s Seventh Annual Forecasting Dinner, sponsored by Iron Capital, BlackRock, Morningstar, Bloomberg, Factset, and Liquidnet. Our speakers were Bob Doll and Brian Singer.

Doll is BlackRock’s chief equity strategist for fundamental equities. His group was formerly Merrill Lynch Investment Managers before Merrill sold their investment management arm to BlackRock in 2006. Doll is an optimist. He has entitled the theme for 2011, “Muddle Through and Grind Higher Plus.” ‘Muddle through’ refers to the economy, which he expects to grow but not without issues. ‘Grind higher’ refers to the market, which he believes will be up in the low double digit return range by year end. The ‘plus’ is his opinion that the risk to his forecast is that he is being too conservative.

One of his more interesting insights, and a major factor in his optimism, is that the average man on the street knows all about the problems facing our government and what bad shape the government is in. This is a cause of much concern and why most people remain negative. However, that same person has no knowledge of how strong corporate America’s balance sheet is and what good shape it is in. Markets are ultimately driven by what is happening to the companies whose shares are being bought and sold, and those companies look good.

In fact, Doll is not only optimistic, but also believes U.S. equities will lead the way. His view is that the U.S. economy will grow twice as fast as any other developed world economy, and while absolute growth still will be faster in the emerging world, the rate of growth will be declining. The U.S. will have positive trajectory while emerging-market countries will have negative trajectory.

He also likes stocks over bonds. His group likes to track the earnings yield on stocks vs. the yield on average-quality corporate bonds. These yields usually track together, but they separated dramatically last year as the yields on bonds dropped. He claims that historically this gap is always filled and the way that happens is most likely that the prices of stocks go up – reducing yield – and the prices of bonds go down – increasing yield.

Brian Singer now has his own firm, but he was previously the chief investment officer for UBS Global Asset Management. Singer is not quite as optimistic. He agrees with much of Doll’s fundamental analysis but thinks 2011 may be one of those years where fundamentals don’t really matter. He sees a clash between positive fundamentals and negative attitudes and thinks the attitude may win out. Interestingly, he said that economic activity was over-stated in the last half of 2010 because people were doing things in 2010 that they would have put off until 2011 but they were worried about changing tax rates and rules. Therefore he thinks 2011 earnings will be softer than most expect. (If you don’t completely follow that argument you are not alone; neither do we.)

Singer also made the point that China is shifting from the world’s cheap manufacturer to a more consumer-based economy. We had discussed that trend in one of our Capital Market Reviews last year, so it is not new to us. What was new is that he believes China is destined to fall apart because of social unrest. Not in 2011, he says, but he thinks in the next 30 years or so, the conflict between free market consumerism and communist rule will come to a head and the result may be China splitting into multiple smaller countries. We found this interesting as we had not heard this exact scenario before.

Both men agreed it will be a bad time for bond investors, especially government bond investors. Both agreed that structural unemployment may be higher in the future than it was in the past, and both agreed that policy makers do not really know what to do about that. They said, as most people now know, 40% or more of the earnings for the S&P 500 companies now come from overseas. What many don’t know is that 70% of the incremental earnings now come from overseas, meaning more than two thirds of the growth in U.S. companies is now coming from outside the U.S. We are truly in a global economy.

We sent you our 2011 forecast last week, so you know by now we are more in line with Doll than Singer. Still, it is important and always interesting to gather the insights of other leading professionals. I hope you found it valuable as well.

Chuck Osborne, CFA
Managing Director

~An Evening of Insights from Bob Doll & Brian Singer