The difficulty lies not so much in developing new ideas as in escaping from old ones.
John Maynard Keynes
Our insights, reflections and musings on the most timely topics relevant to managing your investments.
After a good year for the market, we seem to be ending on a sour note as the market has been mostly down this month going into the last week of trading. Will it continue or will we have a Santa rally? Only time will tell, but my money is on Santa pulling through.
The market today is much like army golf – covering a lot of ground but going nowhere. Why all the volatility? There have been many excuses given by the media, meanwhile we continue to get inflationary signals. Now that inflation is back, every other economic data point must be looked at in this light.
Inflation is a fact, and it is impacting everything from the cost of travel to the Thanksgiving dinner itself. The people impacted the most are those who were already barely making it inside their budget. Still, it is Thanksgiving, and even in a year with high prices there is still much for which to be thankful.
When analytics first came to sports it improved outcomes, because so much of what had happened before then had more to do with tradition than with logic and reason. Knowledge is a powerful thing, and the proper analysis of data can build knowledge. Knowledge, however, is not the same as wisdom. Wisdom comes from the combination of knowledge and experience. Let me give some examples of where analytics gets it wrong.
No one likes corrections, and many investors are downright afraid of them. No one likes seeing the value of what they own going down, even if deep down they know it is temporary. This is the market risk that many investors just do not want to experience. However, there is another risk which is less obvious but far more serious: failing to grow your money at the rate of inflation.
After a good year for the market we seem to be ending on a sour note, as the market has been mostly down this month going into the last week of trading. Will it continue, or will we have a Santa rally? Only time will tell, but my money is on Santa pulling through.
It has been an odd year for markets. We began with great optimism as we were rapidly recovering from our reaction to the pandemic…then we hit the brakes. With an evenly split Congress, this administration somehow believed they had a mandate to be the most progressive in history. What people had asked for was an administration that would stay off of Twitter, be polite, and return to normalcy. We were literally sick and tired of big and bold; we wanted small and competent. That isn’t what we got.
The result is a supply chain nightmare and the highest inflation we have seen in nearly 40 years. In the stock market we began the year with value stocks and small company stocks leading the way after a lost decade; as GDP growth slowed this trend reversed, at least temporarily.
We have had a year without an official 10 percent correction, yet 98 percent of the S&P 500 companies have been down 10 percent or more at some point. Rotation has kept the index itself up. Other areas have corrected, including small company stocks.
We have recently been stuck in a range going up and down and up again. The latest leg has been down. Most of this simply seems like the investors are done for the year. This is not a commentary on 2022; it is simply a function of the market. Mutual funds are paying out significant capital gains after the market has rallied from the pandemic lows in the Spring of 2020. They must raise cash to do so, and this is forced trading. What losses investors have need to be realized by year-end to offset some of the last 18 months of gain.
This is what seems to be driving the market down, not any pessimistic view. As a result, one would think Santa is still coming. The market has gone down, now it is time to go back up. The real direction is flat. How will that change in 2022? I think we just have to wait and see, which is apparently what most other investors are doing.
Meanwhile, I know in my house, and I hope in yours, Santa is coming. Merry Christmas and Happy New Year!
Chuck Osborne, CFA
~Santa is Coming to Town
It is called army golf: Slice the drive to the right, find the ball; hook it way left, find the ball; slice it right…you get the picture. We call that playing army golf because it is just like marching in the army – left, left, left-right-left. That works marching in step with the rest of the platoon, but it is not so great on the golf course. You cover a lot of land without going anywhere.
That is where we are in the market today. Of course, in the stock market it isn’t left-right-left, it is up-down-up. Yet, for all the big moves from week to week, the truth is we are going nowhere. Actually, we are still heading up, just slowly. While the daily and weekly price movements have been dramatic, the trend is still upward.
Why all the volatility? There have been many excuses given by the media (that is their job, after all): The new omicron strain of COVID-19; the slow-down in economic growth; more supply chain fears. All of these things are real issues, but I suspect the reason is simpler than that. Most big investors are just not trading at the moment, and that leaves only fringe players making moves. This tends to exaggerate movements as there are not many people willing to take the other side of any particular trade. Historically this is where brokerage firms would step in with their proprietary trading desks, but that doesn’t happen now, so we get exaggerated moves.
Meanwhile we continue to get inflationary signals. This week we saw labor costs rising and productivity falling. There is nothing wrong with higher labor cost; that means people are making more money. However, what one wants to see is an increase in productivity, or at the very least no change in productivity – this means people are getting paid more and are making more stuff, which keeps inflation down while wages grow, which is what economists call real wage growth. Today, to the extent wages are growing, they are simply being dragged along by inflation. In fact, while workers may have a higher wage, they are losing ground to the cost of living. When wages go up and productivity goes down, we have more money chasing fewer goods…in other words, inflation.
Now that inflation is back, every other economic data point must be looked at in this light. With inflation at 6.2 percent, GDP must come in above that level in order for real growth to be taking place. Wages must grow beyond that level for anyone to actually get a real raise. This is what makes inflation so insidious. The nominal economic numbers will be inflated along with everything else, but in reality, we are going backwards.
From an investor’s perspective, inflation kills bonds and savings. Any return less than the rate of inflation is in reality a loss. Bonds can still play the role of reducing volatility in a diversified portfolio, but they will detract from the long-term return, not add to it. Savings get destroyed, since every day the actual purchasing power of one’s savings drops. Stocks are the hedge against inflation. This does not mean that there will be no volatility and stocks will just climb – that happens only in fantasies. Over time, however, corporate earnings will inflate right along with everything else. It could be real or it might be just because of inflation, but revenues will rise. This, in turn, will eventually be reflected in the stock price.
Ideally, we need policy-makers who were serious about tackling inflation. However, that would mean tightening money supply, reducing government spending, and perhaps most importantly, reforming government regulations that do little other than raise costs. We need Fed chiefs like Paul Volcker, who was nominated by Jimmy Carter. We need administrations who understand that less is more when it comes to government regulation, like Jimmy Carter, Ronald Reagan, and Bill Clinton. We need to once again allow economic reality to trump politics.
That is out of our control, however, so in the meantime we will focus on the hand we are dealt. We may be marching up and down, but the bull market is still intact, and stocks remain the best hedge against inflation.
Chuck Osborne, CFA
So, how do you cook your turkey? This year my sister-in-law and family are joining us for Thanksgiving. They have traditionally fried their turkey and offered to do so for our gathering. That was fine with me – I have had fried turkey only once, but it was tasty. I do have to admit that of all things Thanksgiving, the turkey is not high on my priority list, but it is for my brother-in-law and he was happy to fry away (and doing so clears our oven for other adventures), so that is what we will do this year.
I was explaining this to a client last week who is also a fan of the fried turkey. He, however, was trying something new this year – partly because it is fun to try something new, and partly because the peanut oil he uses to fry the turkey has become expensive. The day after we met, The Wall Street Journal ran an article about the high cost of cooking oil. Inflation is everywhere we look.
The latest reading of the consumer price index (CPI) came in at 6.2 percent, which is the highest rate of inflation in 31 years. It is not going to go away until the policy causing it goes away: That means interest rates have to be allowed to go up, and government must get spending under control. Those things were hard enough to accomplish in 1980, when people may have had political differences but at least agreed that facts are facts, and everyone has to live with the facts whether they like them or not.
Inflation is a fact, and it is impacting everything from the cost of travel to the Thanksgiving dinner itself. The people impacted the most are those who were already barely making it inside their budget. The unmistakable lesson of the government policy of the 1960’s was that it caused the malaise of the 1970’s. These fundamental relationships do not change; the only thing that has changed is that in our modern economy everything happens more quickly. In both periods we had policy designed to stimulate economic demand, with policy simultaneously aggressively attacking those who created supply. This combination has always produced horrible results everywhere and every time it has been tried.
What is an investor to do? The good news is that over the long haul, stocks are the best hedge against inflation. Who really gets hurt is the saver. Stable value options inside of retirement plans are now providing annualized investment results of approximately 2 percent; that is safe in that there will be no market volatility. However, with inflation now more than 6 percent, this means that same saver is losing 4 percent of purchasing power every year. That kind of annual bleeding will wreck many risk-averse savers.
There is more than one risk in investing, and it is often the less obvious ones that are actually the most dangerous.
Still, it is Thanksgiving, and even in a year with high prices there is still much for which to be thankful. In keeping with our tradition, here is my list:
I am thankful…
~ that my in-laws are paying for the cooking oil;
~ that we will be having a normal Thanksgiving in our home;
~ that the other schools in the ACC are really bad at football, thus Wake Forest made it to the top ten for the first time in school history;
~ that Wake Forest is currently undefeated in basketball while Carolina has already lost two games;
~ for my children, who are growing and learning in real – not virtual – classrooms;
~ for my family, immediate and extended;
~ for all of my friends; and
~ for Mama’s pumpkin cheesecake and my loose-fitting pants, which make enjoyment of said cheesecake possible.
~ Finally, I am thankful for you, our clients and friends. Your trust in Iron Capital is our greatest asset, and we value it every day of the year.
Chuck Osborne, CFA
The Atlanta Braves (really the Marietta Braves now, as Joe Buck pointed out during the Game Six broadcast) are the World Series Champs! I am glad, but I do have to admit to struggling to stay awake and being somewhat offended by the constant reference to 1995 being some kind of ancient history. I remember beating Cleveland like it was yesterday, so please stop with the “It has been 26 years….”
Atlanta has been my home for 29 years. I moved to Atlanta in 1992 less than a year after the Braves went from worst to first in 1991. It was so exciting watching that young team that went on to the World Series seemingly every year and lost all but once, which was good for the Buffalo Bills because at least they could point to Atlanta and say, “They are bigger losers than we are.”
Somewhere along the way I just stopped watching. The specific reasons might be an interesting discussion, but that will keep for another day. I can’t tell you the last time I saw the Braves play before Games Five and Six of the World Series this year, but to put it in perspective, when did the Astros become an American League team? I say all this not to disparage, but so that one can understand my shock of two teams making it to the World Series without a single competent starting pitcher between them. The Braves used to have five starting pitchers – you know, back in the stone ages of the 1990s, the last time they won a World Series. Tom Glavine pitched eight innings in the final game in 1995. Times have changed.
Moneyball is what changed it. Other than being an okay movie, Moneyball was the story of how so-called analytics made their way into sports, starting with the Oakland A’s of Major League Baseball. Analysts would crunch data to decide the best moves to make; sports would leave the realm of art and enter the world of science. I am not a fan of analytics, which may be surprising to many since I have spent my entire adult life in the field that has forgotten more about analyzing numbers than most others will ever know. My issues are not the same as many old-school sports fans; my issue is that I see so clearly the huge mistakes that these analysts make.
I see them because crunching numbers in order to make decisions is what I do. The investment industry invented analytics. Behind me in my office on a bookshelf sits the bible – not the Bible, although I own a few of those as well, but the bible of analytics, “Security Analysis,” by Benjamin Graham and David Dodd. It is about twice as thick as the real Bible and harder to read. I doubt most of the analytics guys in sports have read it, but they should. The first chapter of this investing classic is basically a long warning label. To greatly oversimplify, it says you will have more success investing if you learn how to analyze your investments, but (big but) never fall in love with your model. Numbers alone can fool you.
When analytics first came to sports it improved outcomes, because so much of what had happened before then had more to do with tradition than with logic and reason. Knowledge is a powerful thing, and the proper analysis of data (investing data, sports data, or climate data) can build knowledge. Knowledge, however, is not the same as wisdom. Wisdom comes from the combination of knowledge and experience. Let me give some examples of where analytics gets it wrong.
Milton Friedman put the warning this way, “We must reject alike facts without theories and theories without facts.” In other words, we should not believe something without it being backed up by data, but if random data cannot be logically explained, we must reject them as well.
Analytics tells baseball executives that the effectiveness of pitchers decreases every time they see a batter during the game. This has led to the idea that you don’t want your starting pitchers to go deep into games where they start seeing batters for the third time. So, the roll of the middle relief pitcher has expanded. This works in the regular season, but in a seven-game series, those middle relief pitchers are pitching in every game and the batters see them three or four times. This is not my insight, but the insight of John Smoltz, who knows a little about pitching in World Series. He was on that 1995 Braves team.
The analytics guys are knowledgeable. They have a lot of data, and that gives them knowledge. Smoltz, on the other hand, has wisdom. He has all the same data and knowledge of the analytics, but his knowledge is combined with actual experience. The Braves won Game Six because their pitcher pitched six shutout innings, and he could have kept going. As a fan, I was really disappointed that he was not given the chance. While it may be true that in the past managers stuck with pitchers too long, the idea that there is some magic limit which analytics can give you is total nonsense.
It is nonsense because the number of pitches a pitcher can effectively pitch is random. We all know this intuitively. Some days we feel better than others. Anyone who has played any sport or even just exercised knows that for a multitude of reasons we wake up one day and everything is easy, then the next everything hurts. Pulling a pitcher after six innings because a spreadsheet tells you to do so is an abuse of mathematical analysis and it makes me cringe.
In reality, what analytics can give is, at best, a range of normal outcomes. Let’s say on a normal day the pitcher can pitch five to seven innings effectively before losing his “stuff,” as they say. That is what we refer to as the standard deviation. At least two thirds of the time the pitcher can go five to seven innings (six being the median and therefore the “magic” number), but one third, or 33.3 percent of the time, he will either not make it five innings or he can go longer. This is where the spreadsheet needs to meet up with real-world experience. A good manager should be able to recognize one of those days, bad or good, and make exceptions, especially in Game Six of the World Series.
In football people abuse math to suggest that a team should never punt. In basketball, numbers have been mutilated to suggest that offensive rebounds don’t matter. If I still had hair, I would be pulling it out!
Arguments between sports fans are fueled by all of this nonsense, and like most of the issues that supposedly divide us today, the truth is in the middle. At Iron Capital we operate under a set of guiding principles, and one of those principles is to strive for wisdom. We define wisdom as the combination of knowledge and experience. Analytics can bring knowledge, but not until one gets out in the real world and actually gains experience can she achieve wisdom. It matters not whether she is analyzing investment opportunities or baseball strategy; to truly achieve, she has to combine the science with the art. Both are insufficient on their own.
That may explain why, after all these years of not watching baseball, the only people I recognized were the managers. Experience matters. Go Braves!
Chuck Osborne, CFA
~Braves Win, Braves Win, Braves Win!!!
We have been saying for a while now that the market is in need of a correction. No one likes corrections, and many investors are downright afraid of them. Any sign of downward price movement in their portfolio sends them seeking shelter. This is understandable; no one likes seeing the value of what they own going down, even if deep down they know it is temporary.
This is the market risk that many investors just do not want to experience. However, there is another risk which is less obvious but far more serious: failing to grow your money at the rate of inflation. In the last year the fearful investor who put his money into a safe cash-like investment would have been fortunate to receive a 2 percent return. The rate of inflation through August was 5.3 percent. This investor lost more than 3 percent of his purchasing power and in all likelihood doesn’t even realize it. If one were to continue that strategy, he would very likely end up outliving his money.
This has not really been a concern for a long time as inflation had been tamed; however, with the return to economic thinking that led to runaway inflation in the 1970’s, we are once again seeing a return to inflation coupled with lower economic growth. The Atlanta office of the Federal Reserve has a GDP forecast based solely on quantitative inputs, or in other words it is not adjusted up or down based on any human judgement, it is just the facts. At the end of July, this tool projected GDP growth of 6.1 percent; as of September 27, this tool is projecting GDP growth of just 3.2 percent. This is an enormous drop in GDP expectations in a very short time, and it follows actual GDP missing expectations by 2 full percentage points.
If the rate of growth in economic activity is dropping like a stone, then how can it be that inflation is so high? I’m sure you have heard by now, but the global supply chain is a total mess. According to research by JP Morgan, there are more than 70 container ships in a queue outside Los Angeles. That is a record. So, what is causing the backup? It is the combination of spiking demand and a lack of workers.
One can pass the buck to Covid if she wishes, but the truth is, this is the result of policy decisions. Sure, the pandemic may shut down production in certain areas due to outbreaks, but that would ordinarily reduce demand right along with the reduction of supply. However, policy during the pandemic did not just make people whole, replacing their wages mostly or even dollar-for-dollar, which would ease suffering. No, policymakers decided people need to make more money when quarantined than they would in real life. What did people do? They spent it on stuff, lots and lots of stuff. They might have spent it on eating out or going on vacations, but they were not allowed. Stuff is what they could spend it on, so stuff is what they bought. A large quantity of this stuff is now sitting in ships anchored outside of ports, waiting for the people who bought the stuff to actually come back to work and unload it.
Meanwhile, the experts at the Fed have been telling us that the spike in inflation is “transitory” (which I thought meant temporary or fleeting, but evidently they have a different definition). It is true that the latest inflation reading was 5.3 percent and that was down from 5.4 percent; however, JP Morgan points out that this decrease was mostly from declines in airfare, lodging and rental cars, which can be attributed to the Delta variant. This will likely bounce back, and other categories are still rising sharply.
It appears that people are waking up to this. In the last week or so the interest rate on the 10-year Treasury has risen from the 1.3 percent range to more than 1.5 percent. That may not sound like much to a lay person, but this is a sharp rise in a short period of time. However, even with a 1.5 percent yield, that means a loss in purchasing power of 3.5 percent per year when compared to inflation being more than 5 percent.
In my opinion, inflation is the real risk in the market, not volatility. We are likely due for a correction, but we would see that as a buying opportunity. Stocks are the best long-term hedge against inflation. If the volatility causes investors to run to what they believe are safe havens, then those investors are likely to experience real loss as the cost of living grows faster than their money. In investing, as in life, what people fear and what they should fear are often very different. Don’t fear the sudden drop of a market correction; fear the slow bleeding of inflation outpacing your savings.
Chuck Osborne, CFA
~The Real Risk