“Reason’s got nothing to do with it.” ~ Mr. Gibbs, “Pirates of the Caribbean”

Many years ago when I worked at Invesco, I transitioned from the trust company to the retirement division, where I was the director of investments. On one of my first days in my new office, two blocks farther down Peachtree in the Midtown area of Atlanta, the CEO of the retirement division stopped me in the hall and demanded that I explain why the market was down that day. I responded, “Well, Bob, the market is down because more people are selling than buying.” He didn’t like my answer.

If one listens to the financial media pundits, then she would probably believe that there is always some legitimate reason for market behavior and that the market is always logical and correct. Unfortunately, that is nonsense. The market does do a good job over the longer term in valuing various companies, but on any given day, it goes up when there are more buyers and down when there are more sellers, and why those people are buying and/or selling is anyone’s guess. Maybe an investor sells because he knows something about the company, or maybe he needs the money to pay his child’s tuition. There is no way to know.

Part of the art of investment management is being able to discern when price movement in the market means something from when there is a disconnect between the market and reality. We seem to be in one of those disconnect moments lately, and there are various reasons for it.

For more than a year now we keep hearing from Wall Street that a recession is right around the corner. Oddly, the same pundits who tell us this will also say that the two negative GDP growth quarters we experienced in the first and second quarters of 2022 somehow don’t count. Meanwhile, they keep telling us that the Fed raising rates will cause a recession, and we keep not going into a recession. The initial reading of GDP growth in the first quarter of 2023 was 1.1 percent; the biggest drag was a lack of inventory building. Consumption was closer to 3 percent. The Atlanta Fed’s GDPNow, which is a real-time measure of GDP growth, was 2.9 percent through May 17.

Yet, there are still very few who have been willing to admit they were wrong. Several talking heads have now shifted to claiming that we are in the late phase of the economic cycle – in other words, the business cycle runs from recession to recovery to boom to recession, and we are approaching the end of a cycle where the boom slows and we enter a recession. Cycles historically last five years, although recently they have been lasting longer. The problem with this narrative is that we have had two recessions in the last three years: We had the Covid recession, and then the recession last year that no one wants to call a recession. If anything, we should be at the beginning of a new cycle.

If this weren’t bad enough, the pundits keep screaming the word “crisis” every time a bank is mentioned. We do not have a banking crisis; what we do have is a difficult environment for running a bank, and this environment comes after a prolonged period of arguably the easiest era banks have ever had – they could borrow for free and make almost any loan they wanted and still be okay. They didn’t have to pay anything to depositors to keep them. As interest rates have risen, all of that changed. As the old saying goes, when the tide goes out, we find out who was swimming naked. Two very poorly run banks have gone under. That is not a crisis; that is a return to business as normal. Poorly run businesses are supposed to fail.

Now we have the debt ceiling to worry about. Like all of our politics today, this is mostly theater. Our politicians will play for the camera, telling us how reasonable they are being while the other guys are being careless. In the end, they will raise the limit. They will wait until the last minute because…why wouldn’t they? The drama, while bad for the country, is good for ratings.

While all of this noise is clanging in the background, the reality is that our economy is still growing. Companies reported earnings that were almost 4 percent better than forecast, and well-run banks are actually taking market share from poorly run banks. It is always frustrating when the market disconnects from reality, but this is precisely when opportunities are created.

In times like these, it helps to stay focused on prudent investing and remember the wisdom of Mr. Gibbs, “Reason’s got nothing to do with it.”

Warm regards,

Chuck Osborne, CFA
Managing Director

~Disconnect

The Federal Reserve Bank met last week and did exactly what all the market participants expected: raised interest rates another 0.25 percent. Markets took it in stride and even started to rise…then Chairman Jerome Powell had his press conference, and all hell broke loose.

I think it would help Mr. Powell if he read Proverbs 17:28 before having another press conference: “Even fools are thought wise if they keep silent, and discerning if they hold their tongues.” Alas, the fools just can’t help themselves, and they talk.

Powell did two foolish things, in my opinion. First, he started with a statement about the soundness of banks. He said that “conditions in that sector have broadly improved since early March, and the US banking system is sound and resilient.” This comes just a few days after First Republic failed, having to be rescued by the FDIC and taken over by JP Morgan. I’m sure that Powell’s comments are truthful, and if we knew everything that the Fed knows, we would see that. However, the public impression is that he is delusional.

His second mistake was simply appearing unsure of himself. Who knows why, but he seemed anxious. Leaders must never seem anxious. One problem the Fed continues to have is that they apparently do not understand that economic behavior is at least 70 percent psychological; when a visibly nervous Fed chair says that banks are doing great, everyone who sees him is going to think he is hiding something. Bank stocks get hammered, which is exactly what is happening.

Some helpful tips for Mr. Powell. First, when things are going poorly, the wise thing to do is recognize that right from the beginning. Don’t try to make it seem like everything is okay when it obviously is not. Tell the truth: things are tough. Then, explain why they will get better. Recognize that a bank just failed, then explain why you believe it is likely the last one to do so and that the worst is behind us, assuming that is what he meant by the system being “sound and resilient.”

Additionally, admit that it is time to pause. I believe they left the statement out because they are worried about having to then break their promise. They should stop painting themselves into corners like this, but since they insist on having press conferences, just tell the truth – we anticipate that a pause is in order, although no one knows the future for certain and things may change. Is that so hard? Instead, he has left the impression that they are going to rise again, no matter what. Most, myself included, believe raising this time was a mistake, but they almost had to do it, because they forecast that they would. Stop doing that! Project wisdom by keeping your mouth closed.

Meanwhile, in the actual economy, 79 percent of companies have reported better-than-expected earnings, with 74 percent beating on revenues. That is significantly better than the normal 73 percent that beat expectations for earnings and miles above the 63 percent that beat on revenue. Earnings have come in more than 3 percent better than forecast; that might not sound like much, but that is huge. The real world remains a much better place than Wall Street wants to admit. This isn’t helping stocks at the moment, but it is what matters long term. That is encouraging.

Banks have reported and are doing just fine, which one would never know if he just listened to the media or looked at stock prices. Two poorly run banks going out of business does not mean there is a system-wide crisis. However, as I have said before, a bank crisis is always just one panicked mob away from happening. The media and short sellers are doing everything in their power to make this a crisis, and they could succeed if people fall for it. This is why the last thing we need is an anxious-looking Fed chair. What we need is for Powell to connect with his inner Franklin Delano Roosevelt and remind us that, “The only thing we have to fear is fear itself.”

Panic is never a wise strategy. This too shall pass. Prudent investments will come through in the end. The Fed’s actions are not hurting the economy anywhere nearly as badly as is feared; the speeches, however, are killing us. Please, Mr. Powell – just do your job and for goodness’ sake, stop talking.

Warm regards,

Chuck Osborne, CFA
Managing Director

~Stop Talking

My own brother did not believe me…

Earlier this week I received an advertisement via email. Like so many advertisements I receive, it’s a reminder of everything that we believe is wrong with our industry. This one was from a company named Addepar. And I quote, “Does it take too much time to find each client’s bank exposure and make it difficult to be proactive during market volatility? Wealth managers using Addepar find this information in seconds.”

Let me reassure all of our individual clients: No one on the investment team at Iron Capital needed a software package to reveal our clients’ bank exposure. So, we are not a prospect for Addepar. There are multiple triggers in this advert: First, the realization that a company like this exists because the vast majority of “wealth managers” have no idea how each of their clients is invested; and second, the use of the term “wealth managers.” I often talk about the evolution of the financial services industry, and this example is a case in point. Historically, brokers evolved to be financial advisers because they were not allowed to call themselves investment advisers. In those days, most investment advisers actually referred to themselves as money managers, because that is what they do – manage their clients’ money. Brokers don’t actually do that and are thus not allowed to use that language, so the marketing departments came up with “wealth manager.” People often think I am just making this stuff up, until they get a taste of reality.

That email this week, triggered by the banking tumult, reminded me of similar email ads when our government rolled out the Roth IRA. Unlike a traditional IRA or a 401(k) plan, the Roth did not provide an immediate tax deduction, but the money could grow tax-deferred, as in a traditional plan, and it could be withdrawn tax-free. As an incentive to convert from traditional plans to the Roth, the government allowed a limited window in which investors could transition from traditional retirement plans into Roth IRAs and defer the tax consequence of doing so over several years. My brother, who is an estate attorney, asked me about it, as he was hearing from every broker he knew that this was a once-in-a-lifetime opportunity.

I explained that we did not think that the Roth made sense. The lure of tax-free income in retirement does not outweigh the loss of the immediate tax deduction today. He questioned our analysis, because all these other financial people were saying the opposite. I told him that it was a money grab. This was a once-in-a-lifetime opportunity, yes – but not for investors; for brokers. They could move large sums of money into Roth IRAs and get paid huge commissions on these transactions. He didn’t believe me; he thought I was exaggerating the nature of this industry.

Shortly after that conversation with my brother, I returned to my office to find an email advertisement waiting for me touting the once-in-a-lifetime opportunity to collect huge commissions on the Roth conversion frenzy. I sent it to my brother. He believes me now. Iron Capital was then and still is fee-only, but we still get those advertisements, just as we get advertisements today targeted to brokers who don’t know what investments they sold when. Not much has changed.

Our view that investors are better off in traditional retirement plans than in Roth plans was in the minority. The problem with judging things like this is that one must make assumptions about the future of tax policy. Those in favor of Roth assume that tax rates will rise; that is the only way one can get the math to work. To assume one is better off in the Roth, then she would have to have a higher tax rate in retirement, or at least be taxed the same.

We do not think that is a realistic assumption. Those who disagree point to the current fiscal mess that is our government and simply say that taxes must go up. Fair enough, but taxes in general going up is much different than an individual paying more taxes in retirement. The vast majority of retirees will make less money in retirement than when working and will be in a lower tax bracket. This is consistent with the current reality. To successfully retire, the rule of thumb is that one must replace approximately 70 percent of the pre-retirement income. Tax rates could go up across the board and it would still be unlikely for a retiree to pay more in taxes than when she was working.

That is, of course, if politicians just decide to raise taxes on everyone. When was the last time you witnessed that? Politicians don’t just raise taxes honestly, they look for back doors. They raise only on the “rich,” or they do away with a deduction, or they add a tax onto consumption, and so on.

A perfect example is the new Secure Act 2.0 retirement legislation that passed at year-end 2022. One of the 90+ clauses of this law is an increase in the so-called catch-up contributions in retirement plans: Participants over the age of 50 are allowed to contribute an additional $7,500 over and above the maximum of $22,500 to “catch up” as they are getting nearer retirement. Starting in 2024, those catch-up contributions will have to be deposited into a Roth-type account for any employee making $145,000 or more.

The government is doing this because they know they will get more taxes from a Roth than a traditional account. This is how taxes are raised. It is far more likely that the government will tax the income from one’s Roth than it is that they will raise taxes on every rank-and-file voter. For those saving for retirement, the traditional plan is the best option.

However, the Roth is not without some benefits. For those who are not just defined as “rich” by the IRS but are actually well off and in no need of retirement plan income, the Roth is an excellent estate planning tool to pass along wealth to the next generation. Traditional accounts have required distributions as the investor ages, but Roth accounts do not. In addition, under current law, a non-spouse (children or grandchildren) who inherits a traditional retirement account must take the money out of that account over a 10-year period and pay taxes on those distributions, yet as of now, the same beneficiary of a Roth would not pay taxes on those distributions.

So the Roth could be an attractive option for someone with no plans to use his retirement account to fund his retirement, but for the average retirement investor, the traditional account is still the way to go. Secure Act 2.0 should put an end to any doubt.

Warm regards,

Chuck Osborne, CFA
Managing Director

~To Roth, or not to Roth?

“We hold these truths to be self-evident, that all men are created equal….” Banks? Not so much. Last Friday Silicon Valley Bank failed, and as is the nature of the financial media, they have stoked fear at every turn. There are laws against yelling fire in a crowded theater, and there should be laws about trying to frighten people in the financial markets for ratings.

One of the lessons we obviously did not learn from the 2008 financial crisis is that the term bank can apply to all different kinds of financial firms. The retail bank is where most of us have exposure: They hold personal checking and savings accounts and provide loans for things like cars and home purchases.

The next bank is a commercial bank. Often part of the same bank, the commercial bank provides loans and banking services to businesses. They tend to be very conservative, and most small businesses must find financing elsewhere until they have been able to establish good credit. Both retail and commercial banks are frankly boring, and when it comes to something that should be stable and reliable, boring is a good thing.

The next bank type is the investment bank; this is where the action is. These bankers are deal makers, helping startups get funding, bringing private businesses to the public market and funding mergers and acquisitions between companies. This is the heart and soul of Wall Street (assuming Wall Street has a soul).

There are also mortgage banks that do nothing but home loans, and there are trust companies that custody assets held in trust for various types of beneficiaries. We often do not get into this detail because it is needlessly complicated, but most 401(k) plans are actually trusts, held by a corporate trustee.

What is my point? Silicon Valley Bank is not a typical bank. They were a commercial bank that specialized in providing banking services to technology startups. This is not your grandparents’ savings and loan; this is just about as risky as a commercial bank can get. In addition, they seem to have been incompetent. I know Californians march to a different drumbeat, but were they unaware that the Fed had been raising interest rates for a year now?

They went under because of losses in their bond portfolio. Were they unaware of hedging strategies? Did they not realize the yield curve has been inverted, meaning shorter term bonds actually pay more? Well, they did have an unfilled opening for a risk manager…won’t need that anymore.

The other failures over the last week are all crypto-related. One of them had Barney Frank, former congressman of Dodd-Frank financial reform fame, as a board member…this is why I don’t see the need to read fiction – no author would have dreamed of that.

These failures are all very risky endeavors and not indicative of any problem in the normal banking system. However, all banks are always vulnerable to a run. As Jimmy Stuart taught us, the banking business model is to take deposits and loan that money out. Your money isn’t here, it is in Martini’s house – are you going to foreclose on your friend Martini? If every customer comes to the bank at once and asks for all of their money, the bank will fail. This is why we have FDIC insurance.

This is also why it is even more irresponsible than usual for the financial media to be stoking fear. We are not in a financial crisis, but we can be by the end of this week if everyone sells everything and hides the cash under their mattress. The banking system is built on trust, and while trust takes years to build, it can be destroyed by a simple rumor – which may be good for ratings, but is dangerous for society.

The Fed made it too easy to borrow money and they did it for too long. The crypto meltdown and SVB are symptoms of a lack of actual business maturity. It is a combination of apparent ignorance and astonishing arrogance. There will be more to report on this scenario, but meanwhile we should be thankful for prudent investing. Markets react negatively to shocks, but quality companies bounce back quickly. As I said often during the 2008 financial crisis, panic is never a good strategy, and this too shall pass.

Warm regards,

Chuck Osborne, CFA
Managing Director

~Created Equal?

They say the shortest distance between two points is a straight line. I wouldn’t know because, for some strange reason, I chose a profession and hobbies in which there is no such thing. I’m not sure what this says about my personality…although I did take one of those personality tests in college and it labeled me a wanderer.

I was never sure what that actually meant, although the description that came with it made me sound awesome. (Isn’t funny how every one of those personality descriptions sounds awesome?) I am not sure if “wanderer” really sums me up, but I have been an avid golfer for most of my life, and wanderer would summarize my golf game perfectly. I am not sure if it is possible for the golf ball to travel in a straight line, but I can assure you that none I hit ever did.

Later in life I picked up sailing as a hobby. I was inspired by one of my favorite uncles, who was also the reason I am a Wake Forest Demon Deacon. One thing that frustrates non-sailors about sailing is that the use of the wind for propulsion means it will be a rare day when the boat heads straight to its destination.

I have spent my professional career investing other people’s money. Over that 30-year span, the direction has been primarily up, but I can assure you it has not been a straight line. Straight lines just do not happen in my life. So it was of little surprise, after seeing inflation drop for the last several months with each month’s reading lower than the month before, that the January numbers came in a little higher. Previous months were revised upwards as well.

That brings us to Fed Chairman Jerome Powell’s testimony to Congress yesterday and the market reaction. Powell’s remarks were as expected, and really, little changed. He did say that rates may have to be “higher than previously anticipated,” but what else was he going to say? The Fed will react to the data when they meet, which will be March 21-22. The focus right now is that January’s data, which came out after their February meeting, showed inflation was higher than expected. So, Powell says they will raise rates higher. February’s data, which comes out next week, could change his tune, or not.

The big question I have is: Who expected inflation to just drop in a straight line? In truth, I doubt anyone did, but that doesn’t stop short-term traders from playing their games. Inflation has long stopped being the story for the market; The story is that the Fed raising rates will cause a recession. We believe that story is just wrong. The Wall Street Journal got in the act this week with a story suggesting much the same. However, the traders still believe that higher rates equal recession.

The problem with the rates-recession view is that it makes good news seem like bad news: When the recession doesn’t come, instead of saying, “Guess we were wrong,” the punditry just pushes off the onset. Meanwhile, one important thing Powell said yesterday – which was conveniently ignored – was, “We are not close to having a recession.” It is not a coincidence that market rallies keep occurring when companies are actually reporting results. The real world is doing okay.

If the Fed going from 0 to 4.5 percent on the Fed funds rate did not cause a recession, then a few basis points higher this year is not likely to have an impact. The pundits then say, “Yes, but how long will these high rates last?” My answer is five years, and yes, I am still bullish.

We have had two recessions in the last three years. We are not in the late stages of the business cycle; we are at the beginning, and the normal cycle is five years. Until then, the Fed’s focus will be on fighting inflation, not on fighting a recession.

Too many on Wall Street can’t remember a normal business environment. Their entire careers have been spent with the Fed in what was supposed to be emergency mode. They believe everything is about what the Fed does. They are wrong. Sometimes (I would argue most of the time), the price of a stock is not determined by Fed action, but by the actual value of the company, a portion of which the stock investor owns.

That idea might be old-fashioned, but then again so are 4 percent bond yields.

Warm regards,

Chuck Osborne, CFA
Managing Director

~Straight Lines