Have you ever seen Old Faithful, the famous geyser in Yellowstone National Park? I saw it with my family when I was in college. We took a family ski trip to Montana and after a few days on the slopes, several of us piled into a car and headed to Yellowstone. Just outside the park we rented snowmobiles. My understanding is that this is no longer allowed.

We cruised into the park on our snowmobiles, going slowly and stopping often to check out the wildlife and the scenery. It was beautiful, and we saw elk, eagles, and buffaloes – a lot of buffaloes. Finally, we reached our destination: Old Faithful, the legendary geyser. Time came for the geyser to do its thing and…nothing. We had to wait another 10 minutes or so, when finally water shot up in the air. We all stood there and collectively went, huh. Memes were not a thing back then, but in today’s world I would say that Old Faithful was decidedly meh. We then raced our snowmobiles back (so, no more snowmobiles in Yellowstone, sorry).

Sometimes getting to where you are going can be a bit of a letdown. Even something as special as winning an Olympic medal or the World Cup can end up being disappointing, even to the point of depression. Michael Phelps, the greatest Olympic swimmer of all time, has gone public with his battles over depression after his triumphs. He worked so hard and devoted his life to this singular pursuit, achieved it, and then woke up the same person he had always been.

Psychologists call it the “arrival fallacy.” This is the false belief that reaching a specific goal or milestone will bring lasting happiness. The problem comes when we attach our worth and/or happiness to an outcome. When we do that, we fall victim to two psychological forces.

Hedonic adaptation is the first force. Our brain is designed to adapt quickly to new circumstances. Once the initial thrill of reaching a goal fades, our happiness resets to our baseline, “normal” state. I remember Phil Mickelson winning the Masters, arguably the most prestigious championship in golf. The Monday after the tournament he was photographed in the drive through of a doughnut shop; Sunday night he might have been the Master’s Champion, but Monday morning came and he was just Dad, and his girls wanted doughnuts. We come back to earth quickly.

We are also wired to reward pursuit over arrival, which is the second force. Neurologically, our brains reward the progress and struggle of striving towards a goal, rather than the act of getting there. I have run the Chicago marathon. It was an achievement and to this day it is the furthest I have ever run.

I have multiple stories from that experience, but none really involves crossing the finish line, though I have often marveled at how much I was able to eat that night. When you train for a marathon, people will tell you that you run 20 miles and then you run a 10k. While I had never run 26.2 miles before that day, I had run more than 20 miles multiple times in training, and I have run countless 10ks; this time I was just doing it with the city of Chicago cheering me and the thousands of other runners on. The race was on a Sunday. Monday I flew home to Atlanta, and I was at work on Tuesday. From that day on I can say I ran a marathon, which, combined with a valid credit card, will buy a coffee at Starbucks.

More importantly, it showed me a great truth: Running a marathon is not much of an achievement; successfully training for a marathon is a great achievement. Running that Sunday 24 years ago was actually fun, while the struggle was the multiple Saturday long runs by myself or with a few partners – no one cheering, no one lying and telling you, “Only one more mile,” no one randomly passing out beers at mile 22; just you and the road for mile after mile. That is the achievement.

This brings us to retirement. After all, that is the goal of all of this investing, isn’t it? We just need to make it to retirement. In my practice we have had the good fortune of helping many people retire, and most who do so have put in those miles. They do everything right: They live within their means, save, and invest. They joined their employers’ retirement plan early and contributed as much as they could.

They visit with us and create detailed financial projections and model all kinds of contingencies. Then the day comes, and they finally do it: they retire. My father met that description. He retired at roughly the age of 65. It lasted for approximately six months and then he went back to work. He was around 80 when he finally retired for good. That final retirement lasted 14 years. It was not an easy transition for him, and he is not alone.

I was recently shown a YouTube video by a so-called retirement influencer who claimed that the “you will be bored” reason for putting off retirement is a myth. That may well be true for him, but speaking as someone who has been helping people do this in the real world for more than 30 years, lots of people struggle with retirement. Many don’t, and great for them; but for those who do, it is often a case of “arrival fallacy.” They think everything will be fixed by no longer having to go to work, yet they find they are the same person with the same problems, but they no longer have a job that gives them meaning and social interaction.

Arthur Brooks is an author and Harvard professor whose main area of research is happiness. He says that there are three “macronutrients of happiness:” enjoyment, which comes from a balance of pleasure and engagement; satisfaction, which he defines as the feeling of working hard to achieve a goal and successfully reaping the reward; and meaning, or having a sense of purpose and coherence in your life.

Most of us get at least some of those “nutrients” from work. Work provides deep engagement; it puts us into the striving towards something mode, even if that something is just the day when we don’t have to work anymore; and it gives us a sense of purpose and coherence.

No wonder retiring can be a challenge. Too few advisers engage with their clients about these non-financial obstacles. What are you going to do when you are retired? There is a limit to how much golf you can play, and sipping cocktails on a beach is fun in moderation, but if that is your idea of retirement, you might want to investigate rehab facilities now.

The failure to have a realistic life plan for the retirement years is, in my opinion, the primary cause of one of the biggest pet peeves of many financial advisers: Getting their clients to finally spend their money. Those who are financially ready to retire have made the habit of always saving, always investing, always planning and optimizing. The purpose of all of those good habits was to get her to the destination and now that she is there, it is just meh.

She wants to be striving towards the goal; that is where real joy lives. She wants the enjoyment of deep engagement and the satisfaction of working hard. Making it to retirement provided meaning and purpose. Now we are here, now what? Let’s keep planning, keep running scenarios, keep optimizing.

Wall Street will encourage such activity. Wall Street makes money on transaction volume. They don’t want clients to spend their money, since they can’t charge money that has been spent. They don’t want clients settling on one retirement strategy that works, because they make money on transactions, and the more rebalances and more optimizations, the better. Legendary investor Michael F. Price said it best, “Wall Street is in the business of generating fees for Wall Street. Period. It’s not in the business of getting good investment results. You have to separate from Wall Street to do that.”

This is especially true in retirement, and clients are not the only ones who struggle with retirement. The investment industry still cannot figure it out. In our recent podcast we had the pleasure of being joined by Andrew Jacobs van Merlen, co-portfolio manager of T. Rowe Price Target Date Strategies. He and his colleagues manage more than $585 billion in retirement assets. He pointed out that the industry, which now manages $5.2 trillion in retirement date options, still cannot figure out “retirement” because everyone’s retirement is unique.

What most have done is just kept investing like they did in the accumulation phase and hope the total return is higher than the income needs. In our experience this just adds to retirement anxiety – the psychological need to keep acting like we are not there yet. The underutilization of resources, the constant need to reevaluate. This is why we use our income strategy to generate the income needed and not rely on capital appreciation: it allows the retiree to know that the income will be there even in a bad market.

Still, a successful retirement requires more than just financial ability. We must find new ways to sustain those macronutrients of happiness. What will bring us enjoyment, satisfaction and meaning? That answer is different for just about every individual. One size does not fit all. Travel isn’t enough, unless you are going to travel slowly by sailing around the world and staying in places for months at a time – then it could take a decade, but most modern travelers take trips which last days, maybe weeks. Even if you travel two full months out of the year, there are still 10 more months. Hobbies help, but there is only so much golf to be played.

To be successful in retirement, we need to make it our next stage of life and not a destination. As such, the challenges of making life meaningful remain the same. It may not be a gold medal. In today’s world you might not even get the gold watch, but retiring is an achievement. Once the immediate celebration is over, we are all going to wake up being the same people we were before. Each of us has to find our path to meaning. If you think yours is a trip to Yellowstone to see Old Faithful, be warned; you might be disappointed.

Warm regards,

Chuck Osborne, CFA
Managing Director

~Is That It?

Passive or active? That is the question investors often ask. What they mean is, should I invest in a fund that is “actively” managed or should I invest in a “passive” fund that simply mirrors a market index? There are good arguments for both approaches, but more importantly, is that even the right question? The correct answer to the wrong question is still a wrong answer.

First, some background. Index investing has become increasingly popular. The concept is easy to understand and it has the advantage of being inexpensive. If the fund one invests in simply buys all the stocks in a given index, then there is no need to pay analysts to research companies. This allows for a reduction in the fees. It should be noted that there is no such thing as a free lunch. Many people will refer to index investing as buying the “market,” but this is not correct; the actual index exists only in theory. There are no transaction or management costs involved with the observation, and the tracking of stock returns in no way impacts the return in the real world.

Using an analogy, the index is just an observation, like standing on the bank of a river and observing the beauty. Watching the river does not change the river, but if one were to wade into the river, then his presence changes the river: the water must flow around his legs. Fish may become aware of his presence and try to avoid him or come to investigate this new obstacle. It may not seem like much, but once one enters the river, the river is no longer the same. The same phenomenon happens in the market. Index funds, whether they are mutual funds or exchange traded funds (ETFs), buy all the stocks in the index. Those transactions have a cost; they are low in our modern market, but still exist nonetheless, and as a result, the index funds do not perfectly track the index. The returns will always be slightly less than the index returns.

More importantly, those investments, like all investments in the market, have a greater impact. When those stocks are purchased (or sold), it impacts their return, which in turn impacts future investment decisions. In other words, there is no way to truly invest passively. The river will never be exactly the same once one wades into it, and the market will never be exactly the same once one invests.

Obviously, the smaller the investment the smaller the impact and the larger the investment the larger the impact, but every single transaction influences the market. So, is there any such thing as passive investing?

I don’t see it as much today as I used to, but many years ago it was common for us to meet a new client and hear that a parent had left them with shares in one particular company. Living and working in Atlanta, it was usually Coca-Cola. The parent bought shares many years ago and held onto them. Many times, they had taken physical delivery of the stock certificates and put them in a safe or bank deposit box. What had been a relatively small investment had grown into substantial wealth. That is passive investing.

That is not what index investing does. The various indices are made up of stocks of several companies, all of which are chosen either mathematically or by a committee. The most popular index, the S&P 500, is roughly the 500 largest companies in the United States, but the specific companies are selected by a committee to represent the larger economy. The committee rebalances quarterly and can make changes at any time. Today the turnover of stocks in the index is approximately 15 percent. In other words, approximately 75 of the S&P 500 companies are replaced every year.

In the 1960s before index investing existed, the average holding period of a stock investor was eight years. Today index investing is extremely popular and the average holding time of a stock in less than six months. In other words, the more people invest in index funds, the more “active” investors have become.

I know what you are thinking: This is a fascinating thought experiment, but everyone knows that “professional investors never beat their benchmark.” If only everyone “knowing“ something made it true (everyone used to “know” that the world was flat). The studies that show the outperformance of the index are almost all based on just one of many market indices, the S&P 500. It happens to be the hardest to beat, which makes sense logically as it represents 500 of the largest companies in the United States. These are the best-known, most researched companies in the world. It is almost impossible to have any advantage in knowledge about any of these companies.

The same is not true with smaller companies or companies headquartered in other countries. It certainly is not true with bonds, where buying every bond in the index is not usually possible as there are a finite number of bonds and they are all not for sale at any given moment. Professional managers in all of these categories tend to add value. We wrote about this in our fourth quarter 2010 Quarterly Report newsletter, “Indexing is Evil!”.

So, it is not as simple as many would like to make it out to be. Regardless we come back to the fact that there are increasingly more index investors while simultaneously the market has gotten more active. This is largely due to the move away from mutual funds and into ETFS. When index giant Vanguard founder Jack Bogle first wrote about index investing, investors chose to do so through low-cost mutual funds. Mutual funds are investment companies in which an investor can invest and the fund will, in turn, invest that money as described in a prospectus. In the case of the index fund, the prospectus would say that the proceeds would be invested in the stocks of the companies in the index. Investors can deposit more funds or withdraw funds daily at the end of the trading day. The structure of these funds leads to longer-term holding periods.

An ETF is a fund that sells shares directly on the market and thus can be traded any time the market is open, just like the underlying stocks themselves. The original purpose of the ETF was to give institutional investors a place to temporarily park money before allocating it to a portfolio manager who would then invest money on behalf of the institution. Once the ETF was introduced Wall Street found other uses, and today most index investing is done through ETFs.

Give Wall Street a new toy and it will figure out how to abuse it. The idea of index investing being a buy and hold, passive strategy went out the window with the popularity of the ETF. Today the most rapid traders in the market trade entire sectors instead of just one or two stocks through the use of various ETFs. There is a bit of irony in using what is labeled as a passive investment to be more active than investors of the past could even imagine.

This causes all sorts of short-term dislocation. One of the more popular market narratives today is the idea that AI will displace software. The strong form of this hypothesis says that people will just use AI to create custom solutions instead of buying software, in which case software companies are going out of business. The weaker version is that AI will greatly increase one’s productivity and therefore companies will need far fewer software seats, in which case software companies will simply have lower revenue as they sell less of their product.

I am not convinced that either of those cases will come to be, but as the saying goes, one cannot fight the market. In years past, traders who are acting on this narrative would have identified the weakest software companies and sold their stock short, while today they simply use a software ETF. This has the effect of strong software companies, even those who benefit from AI, having their stock thrown out with the bath water because they happen to be in the same ETF as companies that will not survive.

All of this creates an environment where, in my view, the market is becoming less efficient at accurately pricing individual companies. At the same time it is more efficient, if by efficient one means it is hard for active managers to beat.

Ultimately, this is the problem with index investing. We often forget why the stock market exists and the crucial role it plays in our system. The stock market is like a farmers market. Today’s farmers markets provide a place where local farmers, and increasingly local makers, bring their goods to sell to the public. It provides a central place for consumers to go, but it is mostly for the benefit of the farmers. Similarly, the stock market provides a place where companies can come to sell their stock. Yes, it also provides a central place for investors to shop stocks, but it is mostly for the companies. This is how capital is allocated in a capitalistic system. If every investor were to become an index investor, our system would cease to work: Instead of capital being allocated by merit, it would be allocated based on size, and the biggest companies would get the most investment. In other words, the rich get richer and it becomes harder for smaller companies to emerge.

We are not there yet, but with every additional dollar invested in an index, we get a step closer. At the end of the day there may be little difference between the central planning committee of a socialist country and the S&P 500 committee. When the broad market, in other words the general population, stops allocating capital and delegates that responsibility to a small group, the results are likely the same.

What are we to do? I would argue that the opposite of passive investing is not active investing, but intentional investing. A rewarding life is a life lived with mindful intention. This is why we believe that prudent investment is done from the ground up: We should select the companies to which we want to allocate our capital with purpose and intention. When we cannot do that directly, such as in a 401(k) plan, then we should use managers who still invest in this manner.

Then we should bring the passive back to passive investing: Invest in high-quality companies and own them for long periods. Over the last five years, Nvidia’s stock is up more than 1,000 percent. How many investors have owned that stock for the whole period? There have been large ups and downs, with the stock dropping one point approximately 70 percent. It isn’t easy being passive. Selecting high-quality companies and holding them for long periods is a wonderful way to invest, if one has the discipline.

That does not mean that every investor who does so will beat the market, but if done prudently with a focus on the return needed while being risk averse, these investors have a great probability of achieving their financial goals. To paraphrase Benjamin Graham, achieving an adequate return is easier than most people think; achieving superior returns is harder than it looks. I have been helping people achieve their goals for more than 30 years, and I have yet to meet the investor whose financial success depended on beating the market.

There is a scene in the 2005 romantic comedy “Hitch,” when Will Smith’s character, Alex, tells Eva Mendes’ character, Sara, to, “Begin each day as if it were on purpose.” It is a line taken from author Mary Anne Radmacher. We should invest that way, too. The next time you make an investment, including reallocating your 401(k), do so as if it were on purpose.

Warm regards,

Chuck Osborne, CFA

~Intentional

I don’t know if this is true in your house, but in mine, few things are quite as dangerous as eating the last cookie. Not only will the guilty party be scolded over his/her offense, but he/she also will be accused of eating “all of the cookies.” This is especially true this time of the year as the Christmas aftermath is slowly but surely consumed.

In our house we go much of the year without any cookies at all. Perhaps if there is a special occasion, there might be one batch of one type of cookie. Around mid-December, that all changes: We receive cookies as gifts; the children participate in cookie swaps; and of course, we feel obligated to make our own traditional favorites to celebrate Christmas. Most years the cookie supply peaks around December 23, at which point either my wife or I will usually make a comment about over-doing it and finally say, “We will never be able to eat all of these.”

At that moment, no one in the house cares who eats what cookie; the cookies have practically no value. No one is fighting over cookies or hiding cookies, as we are living in the land of cookie abundance. Then Christmas passes. We continue to indulge in cookies through the New Year holiday, and in early January, certain individuals begin to notice certain varieties getting low in supply. As this happens, behaviors start to change: Some cookies will suddenly “disappear” from the usual cookie location. Individuals will start declaring ownership of other cookies. Gifts that were addressed to the family suddenly become the possession of the person closest to the giver. Then, finally we are down to the last cookie. Woe unto thee who eats the last cookie. The last cookie is never eaten openly; it must be consumed in secrecy so that the guilty party may claim innocence. “What cookie? I thought those were gone days ago.”

What we witness every holiday season is a perfect example of the economic law of supply and demand. When cookies are in overabundance they have little value, but as the supply shrinks, the value of each cookie grows until we are down to only one.

One of my most frequent comments over the last several years has been that I no longer understand how they teach economics today. I started saying that roughly around the time when the Fed kept saying that inflation was “transitory.” I was an economics major in college, and I still think like an economist. More specifically, I think like a microeconomist. Microeconomics is the study of how individuals and individual businesses make decisions. It gives us the laws of economics – laws that are consistently observed in reality. Macroeconomics is the study of top-down national and global economies. It is more used in policy-making and is what most people think of when they think of economics; it is also what give economics a bad name.

I saw governments forcibly restricting supply while also attempting to stimulate demand. That is a recipe for inflation. It was so simple for anyone who had a passing grade in Microecon 101 that I could not understand how an institution like the Fed, which is largely staffed by individuals with PhDs in economics, could possibly misinterpret what was happening… which makes me wonder if microeconomics is even taught anymore.

Supply and demand are like lots of fundamentals, which we seem to have lost in our modern society. It is really a simple concept, but understanding it is incredibly useful because it explains so much of what happens in our world, both good and bad. Several years ago, I read an article about the teaching of phonics in California elementary schools. They had moved away from it and saw literacy rates go down, and so they brought it back. It worked and literacy rates rose, but the teachers hated it, because it was boring to teach such simple fundamentals. They killed it again, and literacy rates once again declined. Has the same happened in schools of economics?

The same thing certainly has happened in sports. Youth coaches used to understand that their job was to teach the basic fundamentals, but it is so much more fun for the coach if they skip straight to strategy. Simple fundamentals are boring, but they are also essential.

The price of everything is determined by the supply and the demand for that item. The “right” price is the price where supply and demand are in balance. If the demand for an item increases, then the price will increase, which then incentivizes suppliers to increase the supply. When the supply then outpaces demand, the prices will fall, which will stimulate more demand and incentivize suppliers to cut back. Ultimately a balance arrives where supply and demand match if given the freedom to do so.

I suspect that if you asked most people on the street if they understand supply and demand, they would say yes. I also suspect if you then asked them how a business could maximize its profit, they would say by raising prices…which is proof that they do not, in fact, understand supply and demand.

Let’s start a fictional manufacturing company that makes the almighty widget. The current price of the widget is $10, and we sell a million of them at this price for total revenue of $10 million. The cost of making widgets is $8 per widget, so we have a $2 million profit. Many believe we could increase our profit by increasing prices to $15. However, the increase in price will reduce the amount demanded. Now we only sell 600,000 for a revenue of $9 million. If we produce less then costs will also go down, but a good portion of the previous $8 per widget cost is fixed, so the cost per widget at the lower production level is $12.50. While our profit margin rises a little to $2.50 per widget vs. $2.00 per widget the total profit drops to $1.5 million.

On the other hand, if we lower the price to $8 then we could sell 1.5 million units, which would mean $12 million in revenue. The higher volume would reduce our cost per widget, but only to $7, which would lower our total profit to $1.5 million. So, in this fictional example, $10 is the “right” or equilibrium price.

The incentive of all business owners is to increase volume by reducing price and to use scale to reduce the cost of production per unit. This incentive is balanced by the fact that price alone does not determine demand;

Quality must be maintained, otherwise the widgets lose utility to the buyer and demand disappears completely.

This is how supply and demand work. So, will reducing tax rates actually increase tax revenue? Some will say yes while others argue of course not. The truth depends on where we are lowering from. As with everything, there is a balance. Taxes are the price of profitable economic activity; if that price is too high, then people will reduce economic activity and less tax revenue may be the result. It is also true that there is a limit to lowering rates, which we explained in detail in our third quarter 2010 issue of The Quarterly Report, “A Taxing Debate.”Neither political party seems to understand this simple truth.

The lack of understanding of simple supply and demand also explains the failures of the Affordable Care Act. To balance supply and demand, the price must be known. The Affordable Care Act does not do anything to reduce costs in our healthcare system; if anything, it does the opposite. It produced a wave of healthcare professionals who have left the traditional healthcare world by either retiring, or by starting so-called concierge doctors’ groups. Then it subsidizes the cost to keep the price artificially low. Now it is easier to be insured, but harder to actually see your doctor; it reduces supply while simultaneously stimulating demand through subsidies. This occurred because it focused largely on the cost of insurance, which was a symptom, while not focusing on the actual cost of healthcare, which was the disease.

The same Fed PhDs who missed inflation a few years ago do not understand that tariffs are not going to cause inflation today. Prices are set by supply and demand. While finding the equilibrium price takes some experimentation, a well-run business figures it out pretty quickly. That price has little to do with their cost. Tariffs raise the cost of doing business, which makes the business less viable. Tariffs reduce economic activity and if they are bad enough, which they were in 1930 but have not been thus far this time, they cause depression and deflation.

Today the same mistake is being made in New York City with its real estate affordability issue. If affordability is an issue, that means the supply of whatever item we are discussing has been suppressed. If we want to make apartments in New York more affordable, then we must find ways to increase the supply of apartments. Rent controls do the opposite; they provide a disincentive to increase the supply, as do zoning regulations, building codes etc. They increase the cost, which reduces the viability of building new apartments. Please don’t misunderstand – we may decide that certain zoning rules are desirable and building codes absolutely necessary, but we also have to understand that they come with a cost.

The search for the equilibrium of supply and demand is full of tradeoffs; the reality of supply and demand forces us to face those tradeoffs and deal with them as mature adults. We have to make the hard choices. Even if the local authorities in New York City do everything right, the city will still be a very expensive place to live. There are millions of people, which means demand is very high, and it is made up of islands, which means the supply of land is not going to increase.

That may be unpopular to hear, but it is the truth. Apartments will always be more affordable in my home town of Atlanta; we have far fewer people, and there are no natural barriers to expansion. This brings about other issues because there are always tradeoffs; the traffic in Atlanta is horrible. A simple understanding of supply and demand does not solve every issue, but it does help crystallize the question at hand.

This mindset helps immensely in investing. The new year marked the end of Warren Buffett’s famous career as he retired at age 95. One of his investing principles was to invest in companies that had competitive moats, which restrict the number of competitors and therefore the supply of their product. These moats boost these businesses in the same way that the Hudson River boosts New York real estate prices. Supply is the key.

If we want a more affordable world, then we need to stimulate the supply of things we need and want. We need housing, education, and healthcare to be as readily available as cookies on Christmas Eve. Until we learn that lesson once again, we will continue to have the high cost of limited supply, which only leads to the blame game. Who ate the last cookie? Was it you?

Warm regards,

Chuck Osborne, CFA

~Who Ate The Last Cookie?

We were in an outdoor café in downtown Warsaw. Invesco had entered into a joint venture with a French insurance company and the Polish Post Office as one of a small handful of western asset managers partnering with what seemed like unlikely local firms to give Polish citizens options for managing their government retirement benefits, similar to our Social Security. (Yes, there is some irony that a former communist country had no issue privatizing their program while the U.S. never could, but that is another story.)

Sitting in that café, my two French colleagues and I were in complete agreement: Warsaw was a much better city than we had ever imagined. Before changing your European tour itinerary, let me be clear – we all agreed that in this case, low expectations helped. We had all been overly pessimistic about what we would find in this formerly communist city.

In investing, as with travel, low expectations can be a good thing. Look back at 2023 and 2024, when most of Wall Street kept saying that recession was right around the corner. The so-called yield curve had inverted, and groupthink said that must mean recession. For those who speak English and not invest-speak, the yield curve is the line that forms when one plots the various interest rates of U.S. Treasury obligations of different maturities.

Quick reminder: bonds are simple loans, so when the government borrows money, it issues bonds. Government bonds are like other loans in that they can be for differing periods of time. A credit card allows a responsible user to borrow money today and pay it back at zero interest when the bill comes next month, or not pay it back and pay outrageous interest. A car loan is traditionally for five years or less, although they are getting longer as car prices increase. A mortgage can be for 15 or 30 years. Similarly, the government borrows for different amounts of time ranging from 90 days to 30 years. All else being equal, the longer an investor has to wait to get her money back, the higher interest rate she will demand. This means the “normal” yield curve slopes up and to the right. The rate on 10-year bonds will be higher than the rate of 5-year bonds, which are higher than 2-year bonds, etc.

While this relationship generally holds, there are times when it doesn’t, and the post Covid world has been one of those times. When the longer termed bonds have lower interest rates than shorter term bonds, we say the yield curve has inverted. Historically this has often signaled a recession, but that did not hold up this time around, much to the embarrassment of many pundits. Too many got fixated on this one indicator and refused to see the rest of the positive picture.

Pessimism can be blinding, and it is an easy thing to fall into. I have been writing these Quarterly Reports for more than 20 years now and one of my favorites from early on referenced the movie “Men in Black.” To quote Agent K (Tommy Lee Jones), “There’s always an Arquillian Battle Cruiser, or a Corillian Death Ray, or an intergalactic plague that is about to wipe out all life on this miserable little planet…”. I don’t know if any of that is factual, but Agent K has a good point: There is always something – a geopolitical issue, high valuations, uncontrollable government debt, and yes, as we have witnessed, even a plague – ready to wipe out our 401(k)s.

Fear sells, and there are plenty of people willing to take advantage of that opportunity. One need to look no further than cable news and social media. My colleague Michael Smith often says that Bears (to use the market-based pessimism) always sound smarter than Bulls. He, too, has a point: Today, Bears can talk about wars in Eastern Europe and the Middle East; runaway government debt throughout the developed world; sky-high market valuations; a weakening labor market; stubborn inflation; government shutdowns; and so on. So many Carillion Death Rays aimed right at this miserable little planet, woe is us.

One can grab any one of those topics and spin a tale of doom and gloom about the stock market and even the future of the United States or all of Western Civilization, for that matter. He can make it sound deep and well-conceived. On the other hand, the bullish positive message just sounds naïve: “It will all be okay, guys.” That just doesn’t resonate against all of the pessimism, which is unfortunate, because while the future is always uncertain, “it will all be okay” is the most probable outcome.

This is why we so often talk about prudent investing being done from the bottom-up. It is far easier to analyze a specific company and make the determination for whether to invest in its stock than it is to try to figure out what will happen in Ukraine, how that will impact global natural gas prices, and how much of an input is natural gas to income statements of the S&P 500 companies? That rabbit hole is intellectually gratifying as we love to make connections and show off how many levels of reason we can spiral, but will it actually provide investable insight? Doubtful.

So how do we deal with all the potential negatives? Prudent investing is also risk-averse. Our industry has defined risk as volatility, but this is problematic: Volatility goes in both directions, and investors tend not to be concerned with upside volatility. Volatility is also backwards-looking. The mortgage-backed securities that nearly destroyed the world in the 2008 Great Recession had almost no volatility until they blew up. The most volatile stocks often deliver the highest returns, hence the relationship between risk and reward. We like the old idea of risk, which Benjamin Graham referred to as the Margin of Safety. Price relative to value is, in our opinion, the best measure of risk. When the calculatable value of a company is significantly above the price of its stock, then there is a high margin of safety; if it is the other way around, then risk is real.

The obvious question is: If this is how we see the world, then how could we not be disturbed by the market being at record highs? Because that isn’t a real measure. “Record highs” looks only at price and does not involve value. Also, the market is supposed to be at all-time highs; that is like saying my 15-year-old daughter is at her all-time high height. Children grow, that is what they do. If she were not at her all-time high height, we would be taking her to the doctor to figure out what is wrong. While markets don’t grow in straight lines like children, they do grow over time so being at an all time high is normal.

This is also problematic because it is a top-down view of the whole market, however one wishes to define that term, and the better view is from the bottom-up. There are plenty of companies that are not at all-time highs. One example would be Duolingo, a company that provides a language learning app. This stock is down 0.74 percent year-to-date through September, while its earnings per share are up 71.43 percent over the last twelve months. This is just for educational purposes and not a recommendation, but this one example has grown as a business while its stock price has dropped. So, it is not at “all-time highs.” There are plenty of other examples.

Pfizer’s stock price is more than 25 percent below where it was three years ago. It’s price-to-earnings ratio is just 8.59 based on next year’s estimated earnings, while it is 14 times the actual earnings from the last twelve months. So, when people fret about all-time highs and how incredibly expensive the stock market is, they are clearly not talking about Pfizer. These examples are just to show that what is happening below the surface of the market is not always in line with the narrative of the day. The S&P 500 index is at all-time highs and very expensive from a historical basis, but that is skewed by some very large outliers. There are lots of stocks that do not fit that description.

Being optimistic in the face of market pessimism is often very fruitful. As the old adage goes, we want to buy when others are selling and sell when others are buying. However, pessimism is going deeper: According to a joint poll by The Wall Street Journal and the National Opinion Research Center (NORC), nearly 70 percent of people said they believe the American dream – that if you work hard, you will get ahead – no longer holds true or never did, the highest level in nearly 15 years of surveys.

This is truly frightening. One of the secrets to America’s success is that we are a relentlessly optimistic people. We believe the future will be better, and that is important because in many ways this is a self-fulfilling prophesy. As Henry Ford once said, “Whether you think you can or think you can’t, you are right.”

The WSJ-NORC poll did show a small uptick in people believing the economy was good, but in the September 1 article, they followed that insight with this excerpt: “And yet many people in the survey, as well as in interviews, said they felt a sense of economic fragility, even if their finances were adequate or secure today. In a generational cascade, majorities said the prior generation had an easier time buying a home, starting a business, or being a full-time parent rather than in the workforce, while majorities also said they lacked confidence that the next generation could buy a home or save adequately for retirement.”

Home ownership has been such a central part of the “American dream,” and there certainly are issues today. The main problem with housing today is lack of supply, and especially the supply of starter homes. There are multiple factors here but one of the largest is runaway regulation. A few years ago, California mandated that all new houses had to have solar panels. Whether or not one believes this is a good idea, there is no question that it raises the cost of building homes. Solar panels for a house are not cheap. These types of rules make what is already hard seem impossible.

The ability to start a business is directly related to the level of regulation in the particular business. In the early 1980s, a few years after my father moved us from our North Carolina home to South Florida, Dad had the great idea of introducing Floridians to North Carolina barbeque. Today everyone knows of North Carolina barbeque, but that was not the case 40 years ago. When my father proposed the idea to the Stamey family, owners of Stamey’s BBQ in Greensboro, NC, they quickly told him that it couldn’t be
done. The Florida environmental regulations would not allow for all that hickory smoke to go into the atmosphere. Since then, there have been 40+ years of regulation piled on top of what existed then. Some of it may be good, some bad, but all of it makes it more difficult to start a business.

We need to get back some of that American optimism. To fix the real problems in our system we will need some thoughtful regulatory reform; Meanwhile, we can focus on what we can control. From an investing standpoint, low expectations can be a good thing. It’s boring and it doesn’t sound nearly as intelligent as a complex conspiracy of our ultimate doom, but if we prudently invest from the bottom up and manage our risk, things really will be okay, guys.

Warm regards,

Chuck Osborne, CFA Managing Director

~Pessimism Abounds

“Give me liberty or give me death!” ~ Patrick Henry

One of my aunts used to say we were related to Patrick Henry. I was never sure if she meant our family or my uncle’s family, but as a kid I thought it was cool. Who wouldn’t want to be related to that brave patriot? Liberty is America’s defining virtue, not just Henry’s. Our well-known inalienable rights are life – the essential freedom to live as we wish; liberty – freedom itself; and (in case you didn’t see this coming) the pursuit of happiness – the freedom to pursue our dreams. America is not just a place, it is an idea, the home of the free and the land of the brave. In this way we are all related to Henry.

Freedom, however, is under attack from seemingly all directions today. Voters in New York just selected a socialist in the democratic primary. Vice president JD Vance recently admonished conservatives who he claims, “worship the capital M market.” Milton Friedman famously observed that, “Underlying most arguments against the free market is a lack of belief in freedom itself.” This still holds true, but today there is another element from those who lack understanding of what the term “free market” means.

The confusion is understandable as we are constantly surrounded by references to the stock market. Following the stock market is my job, but even if it were not, one cannot escape daily reminders of what happens in the stock market. Every time there is some scandal or a crisis, people are reminded of the unlikability of Wall Street and all that goes with it. I believe many confuse a “market economy” with the stock market, and they are not completely wrong. The free flow of capital, through a stock market, is certainly an attribute of a market economy, but that is not the complete story.

The term “market” in market economy is just the term that economists use to describe the aggregate of every individual economic decision every individual in a free society makes. When a child sets up a lemonade stand, that is the market. It is free because no one has to buy the lemonade, and no one forced the child to sell lemonade; everyone at the lemonade stand is acting of their own free will. The lemonade stand is the purest form of capitalism. There are no regulations, no taxes, just an innocent child setting up a simple business and thirsty neighbors willing to pay for what is usually some pretty bad lemonade. The neighbors get to quench their thirst and feel good about supporting a young entrepreneur, and the child gets a little financial boost and some great life lessons. This is a win-win situation; there are no losers at the lemonade stand. That is capitalism.

For most of my adult life we all understood this. Any time someone tried to attack capitalism, all one had to do was point to the collapse of the Soviet Union and the success of the Reagan / Thatcher reforms in the U.S. and U.K. One did not have to be an economic scholar to see the obvious contrast: Total collapse versus huge success, this wasn’t nuance. Most people, especially in the investment world in which I live, thought this conversation – which had taken up so much oxygen in the 20th century – was over.

That changed with the financial crisis in 2008: Those bank failures magically resurrected the anti-capitalism crowd. The actual crisis was caused, as all true crises are, by a confluence of simultaneous factors, but the long-lost big government/anti-capitalism crowd had a very simple one-word explanation for the whole thing: greed. Capitalistic greed caused the crisis, they said. That explanation sold because it was simple, and it easily identified a culprit: greedy Wall Street bankers. Of course, the idea that greed explained the crisis was and remains absolutely absurd. We wrote about this at the time. There are so many holes in that argument that one could not possibly count them all, but primarily for this argument to work it would mean that greed was somehow new. People have always been greedy, yet we do not live in a constant state of financial crisis. Milton Friedman said it best when he said, “Of course it is always the other guy who is greedy, we are never greedy.”

Wall Street helped the simpletons’ cause by providing anecdotal stories of incredibly greedy, and frankly often stupid, bankers. I have been in this business a long time, and most people in it do not fit that description, but those who do are ever-present. They contribute to every crisis, but they do not explain a crisis. Let me be clear: this does not excuse the mortgage banking industry or the Wall Street bankers who financed the industry. They certainly deserve their portion of the blame.

However, the crime in that explanation was that it completely exonerated a group that deserves at least an equal portion of the blame: government politicians and regulators. The oft-used quote of the “blame capitalism” crowd was that the crisis was caused by the “unregulated banking industry.” I suppose that I should have known then that the post-modernist idea of truth being whatever you feel it is had taken over our discourse. If there is an industry more regulated than the financial industry, I would like to see it. Yet, I had college-educated people who had purchased multiple homes over the course of their lives look at me in all seriousness and claim that the mortgage industry was unregulated. I would ask them, “Was there a lawyer at your closing? How many disclosures and documents did you have to sign?” That is regulation. The OCC, SEC, FDIC, Federal Reserve, and various state agencies all regulate financial firms and have since at least the 1930s.

Today we hear the line that “the free-market economy is not working for everyday people.” We hear this from both the left and the right. However, every single example they give is, without fail, a place where regulation has replaced the free market. To say that the United States is a capitalistic country is mostly correct, but it is not absolutely correct. In reality, all countries exist on a spectrum. The extremes would be a truly free market with no rules on one end, and a complete command economy with government running every single decision on the other. No country can exist on either one of those extremes, but history has shown us that the closer we get to freedom, the better it is for everyone in a country.

So, what parts of our system are not working for people today? In New York one of the big issues is housing and the lack of affordable options. What caused the lack of housing in New York? Rent controls, for starters. When the there are limits on what can be charged, then there will be limits on how many units can be built. Add to that the high cost of construction. Zoning laws, environmental regulations, safety codes, and labor laws all add cost. This is not to say that some of these items, and maybe all, are not worth it, but there is no free lunch. Everything in life is a tradeoff. Every regulation that goes into the construction of an apartment building adds cost. When all these costs add up, but the price that can be charged is limited, then you will have a shortage. To the extent that property owners are willing, or forced, to rent apartments for less than their cost, then that difference has to be made up for elsewhere. One gets a poor mix of rent control and high-end luxury with nothing in between.

As Ronald Bailey points out in “The End of Doom,” shortages do not occur naturally. Free people find a way to balance supply with demand; this is the essence of economics. Shortages exist only when some outside force, usually government, interferes. Rent controls cause a shortage of affordable apartments. The knee-jerk reaction is more rent control, which will lead to even worst situation, which will lead to even more control, and down the road we go. This is the road to serfdom that Friedrich Hayek mentioned in his book of the same name. What else isn’t working? Healthcare and education costs are often brought up as examples, especially for many young people who are riddled with college loans. These are, of course, two places in our system where we see the highest levels of government intervention. On that spectrum between freedom and command, the closer we get to command, the worse everything gets. Yet, the knee-jerk reaction is always that more control is needed.

Still not convinced? Well, what is working in our society? We have trouble getting healthcare, but even the least fortunate today walk around with an item we refer to as a phone, but in reality it holds more computing power than NASA possessed when they first sent an astronaut to the moon. Technology is probably the freest segment of our society, and the cost continually goes down while access is always improving. Sure, there are issues here as well – privacy concerns, unintended consequences of social media, etc. There is always a balance to strike, but the closer we get to freedom – people freely choosing to do what they will – the better systems work. This may be counterintuitive, but history is crystal clear on this point.

So why do we seem incapable of remembering this lesson? It is in our nature to want to control things. This is a major theme of all religions and every lasting philosophy. Free markets are the best economic path, but there it no perfect path. Sometimes people will fall on hard times.

A free world can be a cruel world, there is no doubt. I wish everyone who claims to support the ideas of economists like Friedman and Hayek actually read their work. Both Friedman and Hayek argue for the necessity of a social safety net provided by government. They also pointed out potential pitfalls and certainly criticized specific programs, but both believed that a safety net was absolutely needed in any civilized society.

Freedom works. Why is this so hard for us to understand? Yet capitalism and its political partner, democracy, will always have their critics. I think Winston Churchill said it best when he said, “Many forms of government have been tried, and will be tried, in this world of sin and woe. No one pretends that democracy is perfect or all-wise. Indeed, it has been said that democracy is the worst form of government, except for all those other forms that have been tried from time to time…”. The same can be said of capitalism. It’s the worst form of economics, except for all those other forms that have been tried from time to time. Behind all the arguments against the free market is a lack of faith in freedom itself.

Patrick Henry was calling his fellow citizens to war. He was willing to fight and die, if necessary, to gain liberty. We have enjoyed that freedom for 249 years. It obviously runs through everything we do as investors, but it is so much larger than that. We need to counter those who argue against it. Freedom needs defending.

Warm regards,

Chuck Osborne, CFA

~In Defense of Freedom