The stock market is filled with individuals who know the price of everything, but the value of nothing.
Philip Arthur Fisher
Iron Capital’s quarterly investment newsletter through which we share our views on investing your assets in the current market environment.
The word competition comes from the Latin word “competere,” which is best translated as, “to strive together.” When true competitors compete, they make each other better. Today too many people think being competitive is about winning at all costs. Competitors do not compete against one another; they compete with one another. They strive together, and in the end, both are made better. This is why capitalism works, and why so many don’t seem to understand that. Competition makes us all better.
We tend to want to compartmentalize our politics, as we do with everything else, but in the real world, everything impacts everything else. We can’t separate foreign policy from economic policy from social issues because it all touches everything. This also makes it difficult to isolate a particular policy and know if its impact is positive or negative. In other words, there are no control groups, and learning the wrong lessons is very easy.
College basketball is not the only place where old ideas refuse to die. The financial markets are full of old ideas that simply refuse to go away. For example, we simply must have a bear market because one is supposed to happen every five years. Over the history of the stock market, we typically get a bear market once every five years. The idea here today is that a bear market must be looming because we have not had one since the 2008 financial crisis.
Long term. I have probably used the phrase a million times, as has anyone who has been in the financial world. No matter how one says it, long term, long haul or long run, it is a phrase that has different meaning to different folks. Let’s face it, time is relative…
Freedom works. Why is this so hard for us to understand? It is in our nature to want to control, to believe that someone has to be in control. This theme runs through every ancient religion, and overcoming that desire to control is central to all of them. Yet capitalism and its political partner, democracy, will always have their critics.
I’m a competitive person. There, I said it. I love competition, and I get it honestly. Growing up in my family, almost everything was a competition. My parents both enjoyed watching sports on television and back then there was no cable package that allowed you to watch the game you wanted, which meant often we would watch games we did not really care about. The conversation would go something like this:
“Who is playing?”
“Green Bay and Chicago”
“Who are you pulling for?”
“I guess I’ll pull for Green Bay.” “Okay, then I’m pulling for Chicago.”
We just thought that was normal. If one family member pulled for one team, then you pulled for the other. Otherwise, there was no competition, and what is the point of that?
Today many people seem to look at competition as a bad thing and I guess I can understand why. Many people think they are being competitive when they are not. Several years ago, I read “Changing the Game” by John O’Sullivan. O’Sullivan was a competitive soccer player and a soccer coach on every level from youth to professionals. He tells the story of watching his kids play soccer when they were very young and it was all fun, and right next to their game was a 10-year-old game. In that game there was no fun being had; parents were yelling, coaches were yelling, and the kids were serious as heart attacks. One comment he made hit home with me: he said that having coached for 20 years he knew something about competition, and what he saw on that field was not it.
The word competition comes from the Latin word “competere,” which is best translated as, “to strive together.” When true competitors compete, they make each other better. When great athletes are asked what they miss most in retirement, they usually say the competition; they do not say the winning. Of course it is more fun to win, but the true joy is in the competition itself. True competitors never take short cuts, and this is where the age-old adage comes from, “winners never cheat.”
Today too many people think being competitive is about winning at all costs. Earlier this year, the United States women’s soccer team won the World Cup. During the tournament much was said about the fact they drew a very tough path. Notably, they had to go through France, which many saw as their main rival. Pundits were saying it would be better to have an easy route into the finals. The reaction of the players and coaches was exactly what one should expect from competitors: They wanted to play France. They did not want a short cut, and they couldn’t even understand why spectators thought an easy way would be better.
Many people just do not get it. Competitors do not compete against one another; they compete with one another. They strive together, and in the end, both are made better.
This is why capitalism works, and why so many don’t seem to understand that. Competition makes us all better. I am old enough to remember what American-made cars were like in the 1970s. Then the Japanese cars started becoming popular, partly because of fuel efficiency, but largely due to the reliability; the German cars started eating away at the luxury end of the market for the same reasons. Then, Ford made “quality job one,” and the American cars got better.
Back then many people feared that Japan would surpass us and that we would cease to be the world’s leading economy, which proved to be a false narrative. Today those fears are pointed toward China, and to a lesser extent, the European Union. It is my opinion that this is once again a false narrative. Let’s look at why.
If China is our competition, we need to know what game we are playing. If we are playing football, soccer, basketball or baseball, the high score wins. Then again, if we are playing golf, the low score wins. We are playing international trade.
In my book, when you play trade, the competitor who ends up with the most stuff is the one who is winning; yet many people tend to believe it is the opposite. For years the United States has gotten far more from China then we have given them. Some think that is a problem; to me it sounds like winning, but even then, it is probably overstated. For most of those years, services have either not been counted or under-counted. We are now a service-oriented economy, so we would be winning by far less if we counted correctly.
The more sticky issue with China is its use of intellectual property and so-called forced technology transfers; this is where the current negotiations keep breaking down. As a true believer in capitalism, I have to say that I have mixed feelings here. I certainly do not think someone should steal another’s intellectual property, but is it really stealing? In some cases it may be, but most of the time these were agreements made by American companies who wished to do business in China. Here is one of the great benefits of a capitalist system that often gets ignored: Every single transaction in capitalism is voluntary. No one ever forced Apple to make and sell iPhones in China; Apple voluntarily chose to do so.
If American companies made bad deals that they now regret, why should we bail them out? This is one thing that critics of capitalisms have right: In real capitalism, there is no return without risk. Sometimes those risks come true and when they do, a company and its executives should pay the price. There is no such thing as a business that should not be allowed to fail, and if one drives his business into the ground, then he should have to live with those consequences. True champions are not those who never fail; they are those who fail and get back up. This should be as true in business as it is in anything else.
At Iron Capital, we often tell prospective clients that we have never refused to work with someone because of the size of their portfolio, but we have refused to work with people for other reasons. You see, transactions in a capitalist society are voluntary. We would never dream of spending resources lobbying the government to force those people to be more to our liking. When we really think about the situation, it seems absurd. If we can come up with a national agreement that prohibits technology transfers to China, then that would certainly make individual companies’ jobs easier. However, if these negotiations fail to make such a breakthrough, then we should remember that these companies chose to do business in China. They were not forced.
The trade war with China may or may not pay off in the end; only time will tell. The current situation, however, is clearly slowing our economy. The result is that the Federal Reserve Bank (Fed) has reversed course from last year and begun to lower interest rates. Some suggest that they have not gone far enough. Once again, I am a very competitive person, but even I know that not everything is a competition. Interest rates in the United States are at or very near historically low levels, but compared to places like Germany, our interest rates are high. As of this writing the yield, or interest rate, on the 10-year U.S. Treasury is 1.61 percent, and the yield on the German 10-year is -0.50 percent. This means that if an investor were to loan money to the U.S. government for ten years, then she would get her money back plus interest of 1.61 percent per year. If that same investor loaned her money to Germany, she would get back her money minus 0.50 percent per year.
It has been suggested that the Fed is losing by not trying to match countries like Germany in the race to lower and lower rates. In my opinion, this should not be a competition. Each central bank should be doing what they believe is correct for their country. However, let’s say it is a competition. Once again, with any competition, we have to know how the scoring works. Who wins the high score or the low score?
Let’s give this some thought. What causes interest rates to rise or fall? We know the Fed sets a target for overnight rates, but the rest of the interest rates are set by the market. Investors chose to invest or not to invest in an auction. The prevailing rate is the one that satisfies the most investors. If investors are willing to accept a 1.6 percent return on their investment, it means they believe that return is fair in comparison to what other options they have. In other words, this is a poll on what investors believe the future economy will look like. The higher the interest rate they demand, the more growth they believe will occur in other investments. The lower the rate they settle for, the more they believe other investments will not grow very much. To be willing to accept negative rates is to believe that more money would be lost if one invested in anything else.
With this realization, it sure sounds to me that the country with higher interest rates is the one who is winning. Just to check that theory, look at the current Gross Domestic Production (GDP) growth. In the second quarter of this year the U.S. economy grew at 2 percent. The German economy, on the other hand, shrank 0.1 percent. Germany is on the brink of recession if not already in one. Again, it isn’t a competition, but if it were, we would be winning.
Competitive games are zero-sum. This means that there is a winner and a loser. My daughter loves to play Candy Land and Chutes and Ladders. Anyone who has ever played these games knows that they are actually the same game with different graphics. However, if we are playing one and I win a few times in a row, then we must switch to the other game. In Candy Land and Chutes and Ladders, there is one winner and everyone else loses; there is a plus one and a minus one for a zero-sum.
Life is not like that; life is not a zero-sum game. Life is more like a marathon. Sure, there is some professional athlete who wins the race, but what every serious marathon runner is interested in is their personal best. They compete mainly with themselves, striving together with the other runners to achieve their goals. This is a far better representation of the competition of life.
This is what we try to explain to our clients: When we talk about prudent investing being absolute return-oriented and not relative return-oriented, we are talking about focusing on reaching your goals. We do not want to focus on beating some artificial benchmark or, for that matter, your neighbor. Real competitors know that competition is not win-at-all-costs. Sure, we want to win, and it is that desire that drives us to strive. In the end, however, the striving together is what it is really about. Hopefully our representatives negotiating a better relationship with China and Europe understand that. “Iron sharpens iron, so one person sharpens another.” Competition can make all of us better if we understand what it is really about.
CFA, Managing Director
How does a baby learn to walk? This is a question I often ask at the beginning of every season when I coach youth sports. The answers I get are often entertaining, but seldom do I get the answer I’m seeking. I will hear, “By putting one foot in front of the other.” I might hear, “Mommy helps him.” However, I seldom hear the real answer: A baby learns to walk by falling down, and as any parent could tell you, they fall down a lot.
We learn from our mistakes. That is the point of the lesson. It does not take long for young boys and girls to learn that mistakes are bad. Human nature being what it is, the natural response to mistakes is to deflect or deny, but what one needs to do is own his mistakes so he can then learn from them. Many adults are still working on owning their mistakes. As a coach, I preach this all the time. Learn from our mistakes, and make only new mistakes.
That is the secret to improving at any endeavor. There is one potential problem: What happens when we learn the wrong lesson? This past spring I was coaching my daughter’s soccer team. One of her teammates was inbounding the ball and threw the ball in from the side of her body instead of over her head. Kids do this a lot because they have a dominant hand and that is the hand they throw with. It is not natural to everyone to throw the ball directly over one’s head with both hands. I stopped to point out the mistake. We have a ritual called CLaPing for mistakes. The C stands for “claim” the mistake, the L stands for “learn” from the mistake, and the P stands for “play through” the mistake.
So, I blew the whistle and we clapped for this girl’s mistake. I asked her what she thought the mistake was, and she said something I did not expect. She thought someone else should have thrown in the ball. We straighten that situation out, and the player in question learned how to throw the ball in properly, but it made me think. All this emphasis on learning from mistakes is great, but what happens if they learn the wrong lesson?
This is an easy trap to fall into. It is especially easy when dealing with economic issues. Economics is part art and part science; that is what economists will tell you anyway, and I guess there is some truth to that in the sense that it is at least partially mathematical. The problem with soft sciences like economics is that there is no actual way to test theories using the scientific method. For those who have blocked out their middle school science projects (whether from boredom or years of therapy), here is a quick reminder: The scientist comes up with a hypothesis. To test the hypothesis, the scientist sets up an experiment.
The hypothesis might be that fertilizer makes plants grow faster. To determine if that is the case, the scientist will grow two plants, one fertilized and the other not. To make sure that it is the fertilizer that is making the difference and not some other variable, a good scientist will ensure everything is the same except for the fertilizer: the same type of plant, same soil, same exposure to sunlight, etc. That way, the scientist can know that she is seeing the difference that fertilizer makes. The plant that does not get the fertilizer is known as the control group. It is a vital element of the scientific method.
There are no control groups in economics. Economics is not done in a laboratory; it takes place in the real world. When we make an economic decision, such as buying a house, we cannot set up an alternative universe in which we didn’t buy the house. Years later, we may see the purchase of the house as a great decision or a big mistake, but the truth is we have no way of knowing what our lives would be like had we not purchased that house, and don’t underestimate the importance of that purchase.
It probably will not surprise our clients and friends to learn that in my life, I have owned just two houses. We preach long term and we practice what we preach. My wife and I purchased the second of those houses nine years ago and I now believe that both of my home purchases have been good decisions. Due to the nature of my work, and this newsletter, you all are probably thinking about the financial impact of my purchases. My home purchases have been fortunately well-timed in that regard. My first home was purchased before the Federal Reserve (Fed) fell in love with low interest rates, so I benefitted from the inflating of the housing bubble. My second home was purchased close to the lows in real estate caused by the bursting of said bubble. So, as homeownership goes, I’ve done well.
But, that isn’t what I’m talking about. My daughter, who was born six weeks after we moved into our current house, spends most of her days at home playing with her best friend, who happens to be a neighbor. Being our neighbor is the only connection the two girls have – her friend goes to a different school, a different church, etc. If we had not purchased this house, we would not know this family, and my daughter would have a completely different best friend. What a difference that would make in her childhood.
The house we purchased impacts many aspects of our lives that have nothing to do with the simple math of real estate investment. I believe we have made good choices, but the truth is that I have no way of knowing what our lives would be like had we made a different decision. Economic choices are dynamic and impact more than we realize.
If this is true in the simple example of buying a home, imagine what various impacts economic policy decisions have on our society. We tend to want to compartmentalize our politics, as we do with everything else, but in the real world, everything impacts everything else. We can’t separate foreign policy from economic policy from social issues because it all touches everything. This also makes it difficult to isolate a particular policy and know if its impact is positive or negative. In other words, there are no control groups, and learning the wrong lessons is very easy.
In the 1950s, ’60s, and ’70s, we had very high tax rates. According to the Bradford Tax Institute, income tax rates peaked in 1944 when we had a 94 percent tax bracket. Through the next 30 years, the highest bracket was 70 percent. The 1950s and 60s were a time of great economic expansion for the United States; many now point to this and claim that high taxes do not slow economic growth.
That is a false lesson, desperate for a control group. Two larger forces were impacting our economy at that time in our history. First, in the aftermath of War World II, the United States was the only industrialized nation which had sustained no damage to our industrial capabilities. Every single one of our “competitors” was having to completely rebuild. To this day, our primary ally, Great Britain, remains a shadow of what it was prior to the war. We were the only show in town and as we all know, that kind of competitive advantage can mask many inefficiencies.
In addition to our global industrial advantage, we had our entire Armed Forces full of soldiers and sailors coming home to start families: The baby boom. These families created this new place called the suburbs and an entirely new stage of human life known as the teenage years in which, unlike any generation to come before, parents subsidized childhood consumerism. Lessons from the War translated to technological advances in our homes. What began with dishwashers and air conditioning ended with personal computers in everyone’s homes, just like a young Bill Gates dreamed.
When I was in college, one of my professors liked saying that the economy was stronger than any government. This is what he meant. When a country has historic global competitive advantages and you combine that with booming demographics, policy will be overwhelmed.
That all came to a screeching halt in the 1970s. The rest of the world had caught up, and the baby boom was over. Price controls, which President Nixon thought we could get away with (because it was the kind of thing we had been getting away with), led to one of my most vivid memories of the ’70s: gas lines. One hasn’t really lived until he has roasted in the sun, sitting on the nice vinyl seats in a pea-green Pontiac Ventura with the windows rolled down and the air conditioning off because you were afraid of running out of gas before you could get to the pump…which would happen from time to time and was actually why I was in my sister’s car in the first place. If we didn’t make it, I would have to get out and push while she steered.
Another memory of that time was the purchase of my first suit. My father took me to a men’s store where he bought his suits and introduced me to the salesman who helped him. While I was being measured for alterations my Dad asked our salesman why he was not the manager. He had worked at the store for a long time. The gentleman informed us that he had been offered the role multiple times. He turned it down because the raise that would come with the promotion would put him in a higher tax bracket and he would end up taking home less money.
High tax rates hurt the economy; that means they hurt people, and mostly they hurt people who are trying to move up in the world. They are a hurdle. We finally learned that lesson and in the 1980s, we got tax reform. Thirty years of economic prosperity followed, even though all the outside benefits we enjoyed in the 1950s had long since gone.
Today, we are addicted to low interest rates. The policy disasters which led to the 1970s caused, among other things, high inflation. To finally kill that problem, the Fed raised interest rates. I can remember getting double-digit growth on bank certificates of deposits. Ever since, central banks have been able to stimulate the economy by lowering interest rates…until now. As of my writing, interest rates on German 10-year bonds are negative 0.37 percent and Japanese bonds pay negative 0.14 percent. So if an investor loans money to Germany or Japan for the next 10 years, she will get back less than she loaned them.
Does all of this lowering of interest rates work? The truth is, we don’t really know. The Fed claims to have saved us in the financial crisis, but could that have been a false lesson? We don’t know what would have happened if the Fed and other central banks around the world didn’t lower interest rates to historically low levels, because there are no control groups in economics. What is interesting is that the low interest rates of today are like the high tax rates of the 1950s and 1960s in that their purpose is to fund unsustainable government spending. Then it started as paying for the war and morphed into paying for the “Great Society.” Today we are largely paying for the unfunded promises of yesteryear’s politicians. Only time will tell, but ultimately it seems like a similar end will have to come.
The market is all for cuts in interest rates, but that very well may be a false lesson.
Chuck Osborne, CFA
~The Wrong Lesson
The difficulty lies not so much in developing new ideas as in escaping from old ones.”
— John Maynard Keynes
The University of Virginia Cavaliers are the 2019 NCAA Men’s Basketball Champions. They defeated the Red Raiders of Texas Tech. Both teams got to the final game with a similar formula: tough-as-nails defense and patient ball control offense. In other words, they play slow. A lot of basketball fans don’t like it, and I will admit that I prefer a faster pace game myself, but I suspect that coaches Tony Bennett and Chris Beard would agree with Dean Smith who once said, “I wasn’t trying to make it a good game, I was trying to win.”
The strangest thing about the game to me – other than that it didn’t even start until after my bedtime – was the halftime commentary. I usually love the banter supplied by Charles Barkley, Kenny Smith, Clark Kellogg, and Ernie Johnson Jr., but after the first half in which Texas Tech did not make a single shot from the field for the first seven minutes, Kenny Smith set out to explain why neither of these teams could win the championship. You see, there is an old idea in basketball that if you have the better team then you want to play fast, and since the best teams usually win, most champions have played at a faster pace.
The idea stems from basic strategy. Dean Smith used a golf analogy to explain it and I’ll borrow from that: If I were to play Tiger Woods in golf, my odds of winning decrease with every hole we play. On any one hole, I could get a birdie and he could bogey or worse; however, over the course of 18 holes, the fact that he is much better than I am will give him an increasing advantage.
In basketball, by slowing the game down the inferior team can decrease the number of possessions, giving them a better chance of pulling off an upset. This idea is so entrenched that it has become a common belief that only lesser teams play slow and therefore slow-playing teams cannot win the championship. Kenny Smith played for Dean Smith at the University of North Carolina. Coach Smith might be famous for the four corners delay game, but most of his teams played fast. He was a strong believer in the fast break, and frankly usually had the better team so wanted to speed up the game.
I understand the slower game of UVA and Texas Tech not being Kenny Smith’s cup of tea, but as he sat there arguing that no team can win a championship playing the way that both teams in the championship game play I was wondering what in the world he was thinking? One of these teams had to win. They were the only two teams left, and by the way, they were the only two teams left because they beat everyone they played in the tournament. I don’t know if this is the future of college basketball, but I do know this: the old idea that slow teams cannot win championships was just proven false.
College basketball is not the only place where old ideas refuse to die. The financial markets are full of old ideas that simply refuse to go away. For example, we simply must have a bear market because one is supposed to happen every five years. Over the history of the stock market, we typically get a bear market once every five years. The idea here today is that a bear market must be looming because we have not had one since the 2008 financial crisis.
Before I debunk this idea I must freely admit that I use the five-year average all of the time. Many of you already know this because we have had that conversation. How long should we give a manager to know if she is doing her job? At least five years, because that is the average length of a full market cycle, with the cycle being bear market, recovery, bull market, and then another bear market.
Five years is, however, an average, much like the typical southern summer thunderstorm lasts 20 minutes. Anyone who has lived in the Southeastern United States knows this. However, this does not mean one can simply set his watch for 20 minutes when the storm begins and then safely walk outside. It is not that simple.
This market does not have to go down simply because it has been so many years since it has happened. For one thing, the very idea that the market has not experienced a significant downturn since 2008 is misleading. European stocks suffered their setback in 2011. Most stocks in the S&P 500 suffered in 2016 as only the FANG stocks kept the market above water.
The downturn that occurred in the fourth quarter of 2018 was technically a bear market, which by definition is a market down more than 20 percent. Some are already dismissing it, however, because it lasted such a short time. Granted the only real issue was this very idea that a bear market must happen simply because it hasn’t.
Similarly, there is an old idea that the economy as a whole must go into recession because a recession is supposed to happen roughly every five years. The market cycle mirrors the economic cycle, although the market is usually ahead of the actual economy. Again, the idea is that there is a cycle where business does well, they expand, then they over-build and the economy slows down to adjust. After the recession, there is a recovery and we do it again. The last recession in this country ended officially in 2009. We are overdue based on the idea that this average time span must hold.
Again, the problem here is that real life is just not that simple. In our current circumstance there is a question of when the last recession actually ended. Several years after the technical end of the recession, surveys showed that most people still thought we were in a recession. This is because the “recovery” was the most anemic recovery we had experienced, at least since the Great Depression. The rate of growth was half our normal average, let alone the normal recovery boost. So yes, the recession was over, but it did not feel like it.
Which matters more: the academic definition of a recession being two consecutive quarters of negative growth and the end being a return to positive growth, or what real people feel in their pocketbooks? If most Americans thought we were still in a recession, then I’m of the opinion that we were in a recession. After all, economics is mostly psychological. This does not mean it isn’t real, but it does mean that what actually happens is hugely influenced by what we thought would happen.
For example, if people become convinced that a certain bank is on the verge of collapse, then it will almost certainly happen. It matters not that the bank was perfectly sound when this belief took hold. People believed the bank was not safe and therefore started withdrawing all of their assets from the bank. Enough people withdraw their assets and all of a sudden the bank is actually in trouble – the self- fulfilling prophecy. So, I’m willing to go along with the view that we have not been out of the recession nearly as long as the experts say.
However, even if they are correct, it is clear the economy has not grown in total nearly as much as it usually does in a full cycle. If we are growing half as quickly, does it not seem logical that the cycle would take twice as long?
Of course, even if that were not the case, these timelines are just averages. We do not go into a recession simply because it is time; we go into a recession because businesses and individuals have expanded too rapidly and need to correct that by temporarily ceasing growth or even shrinking it. To use an example many would understand, a recession is like a new homeowner being “house-poor.”
Most homeowners have been there. We fell in love and bought the house which was, in reality, just out of our price range. Now we have this great house and no money. So the annual vacation gets cut. We fire the lawn service and reintroduce ourselves to the lawn mower. We make excuses for not going out to dinner with friends. Time passes, raises eventually come, or maybe we can refinance and things improve.
So, have we bought too much house? There really are no signs of this being the case. The key I always use is the employment situation. Our unemployment rate is at 3.8 percent and has been below 4 percent for longer than any period in our country since the 1960s. Not only is unemployment low, but wages are growing faster than the rate of inflation. More importantly, they are growing faster on the lower end of the scale. This does not make for an economy which is about to go in reverse.
Another old idea is that the Fed raising interest rates will slow the economy. The truth about interest rates, like so many of these ideas, is more complicated. The Fed raising rates early in an economic expansion is usually a good thing; it means the economy is growing again. The economy and the stock market both tend to grow as interest rates rise. It is when rates peak that the economy and the market start to head in the opposite direction. So now our old ideas are related: what one thinks about the Fed’s raising rates is directly related to how close she thinks we are to the end of the cycle and another recession. Late last year all we heard was that we are late in the cycle. If that is true, then the Fed raising rates is bad. But, is it true? One would not know it now. We seem to be still chugging along.
Ultimately all these ideas persist because of the fatal flaw of economics as a science. In the hard sciences, the scientific method requires a control – this group gets the experimental treatment while this other group gets a placebo. The treatment works or it does not. There is no control group in economics. The truth is that we don’t know how much Fed policy influences the real world. Many believe, myself included, that the actions of our Fed in the immediate aftermath of the financial crisis saved us from a far worse outcome. However, there is no way to actually know that. We can- not set up an alternative universe in which the Fed did nothing. All we can do is look at history and attempt to learn as much as possible from it. The problem with that is every time it is a little different: the Fed raised rates and the market dropped in the 4th quarter of 2018; the Fed softened their talk and the market rebounded to begin 2019.
At the same time, the trade negotiations with China looked bleak in the Fall of 2018 and much better in the early days of 2019. Was the market responding to the Fed or to trade talks? This is the problem with these old economic ideas – they are impossible to prove and just as impossible to disprove.
What is an investor to do? Investing is much like basketball in the sense that there may be differing styles, but some fundamentals are constant. Some teams play fast and some play slow. Some investors seek rapid growth and some seek steady income. All great teams play defense. All great investors are risk-averse. All great teams have an identity and they stick to it. North Carolina plays fast, Virginia plays slow, both have now won championships in the last few years. They are who they are. All great investors have a process and they stick to that process through booms and busts. All understand that it doesn’t really matter what others say or think; an idea, old or new, is only good if it works.
Chuck Osborne, CFA
Long term. I have probably used the phrase a million times, as has anyone who has been in the financial world. No matter how one says it, long term, long haul or long run, it is a phrase that has different meaning to different folks. Let’s face it, time is relative. An hour and a half car ride is really not that long to me, but don’t tell that to my eight-year-old daughter, who within twenty minutes will begin the “Are We There Yet?” ritual, shortly followed by, “This is taking forever.”
Most of our readers know that I coach youth basketball. My son’s practices last one hour, and that hour goes by in what seems like ten minutes. For a few years I would help with his baseball team after basketball was over; those one- hour practices seemed to last days. Of course, as any parent knows when one has children around, the days become increasingly long and the years proportionately shorter. This is a phenomenon that I have to admit I do not fully understand but must admit is true.
Different people even have different ideas of what the term “on time” means. I know people to whom anything less than fifteen minutes early is considered late, and others who figure if they are there within fifteen minutes of the start that is good enough. Once when I was five minutes late to a client meeting, one of the committee members let me have it. How dare I keep them waiting? I have been ten minutes late to a client meeting, apologized, and been told that I was being silly for apologizing. People just see time differently.
With so many differences, how are we to define what it means to be long term? I realized this a few years ago while meeting with a client. I was explaining that he had a “long- term” time horizon, and he quickly corrected me, saying that he only had ten years before retirement. I quickly realized that his idea of long term and mine were as different as my idea of a short road trip and my daughter’s. I live in the world of the market, and he lived in the real world.
In the real world, things just do not change as fast. Markets may drop twenty percent from October to December, but reality does not change that quickly. In my world, where things do happen very quickly, the idea of long term keeps shrinking. I personally define long term as a three- to five-year time span. Some would define it as short as a year. I know a stock trader who defines it as six months.
Regardless of definition the term is too often misused and used as an excuse to bury one’s head in the sand during times of distress. “I’m not looking, because I am in it for the long term.” Many are probably familiar with the quote I opened with from Keynes. However, most have probably never read the full quote in context, “But this long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.”
Too often the long term is pulled out by those who do not know what to do and therefore say just hold on and do nothing. Unfortunately, doing nothing is still doing something. Please don’t misunderstand: We should make investment decisions based on the long term, and sometimes doing nothing is exactly the right thing to do; I’m just pointing out that one should not use these terms as crutches when things get a little scary.
So, what should a prudent investor do when the market gets stormy? It always starts with the fundamentals. For us, there are three fundamental rules to prudent investing:
1) Prudent investors invest from the bottom-up.
This means we analyze each individual investment on its own merits as opposed to trying to guess where the market is headed at any particular moment. Individual investments often start to look expensive before market downturns. No one can time the market, but one can pay attention to how expensive an investment is becoming.
In October of this past year, Iron Capital increased its allocation to bonds and decreased our allocation to stocks for all of our clients who have a blended portfolio. We did not, and do not, have a crystal ball. We did not know or expect the market would drop as it did late in the year. We did know that stocks were getting expensive and bonds looked more attractive than they had in many years. This is investing from the bottom-up.
2) Prudent investors are absolute return-oriented.
This means prudent investors do not get involved in the dangerous game of competitive investing, always comparing results to an artificial benchmark or one’s boastful (un-truthful) neighbor. Prudent investors don’t chase Bitcoins because they are the hot item in 2017, and therefore do not experience the 80 percent drop in price when hot items suddenly become cold, as Bitcoin did in 2018. Of course, when market values drop it is almost impossible to maintain a positive absolute return. I know that no client likes to hear that they lost much less than they otherwise would have, but losing less when things are down is often the key to success over three- to five-year periods.
There is another potential issue for the absolute return-oriented investor: Outside factors, such as taxes, can impact some investors. If one has taxable investment accounts, then she may treat downturns differently. Gains on investments are taxed at capital gains rates. An investor does not pay taxes on gains until the gain is realized. In other words, if she owns a stock that goes up in value, she is not taxed unless she sells that stock and pockets the gain. These gains and other income up to regulatory limits can be offset with investment losses. Of course, losses work the same as gains in the sense that one must actually sell the investments to realize the loss.
Many investors dislike selling investments when they are down. They want to hold out for – you guessed it – the long term. There are two things to realize here: First, taxes will impact your absolute return, and the tax deduction from realizing a loss has significant value. Secondly, one does not have to make money back the same way he lost it. He could invest in a replacement. If he owned an airline, then he could invest in another airline. After thirty days he can buy back the original investment and still maintain the tax benefit of the loss. Doing this in a disciplined way can have a very positive impact on the after-tax investment results of a taxable portfolio.
3) Prudent investors are also risk-averse.
This does not mean that we can magically avoid the fluctuations of the market, but prudent investors are always biased toward high-quality investments. They wish to invest in companies that will stand the test of time. They are also very aware of price. Real risk is paying more than an investment is actually worth. This is how permanent losses of capital occur. The pressure to pay these elevated prices flow from competitive investing and the feeling of missing out on something.
These two forces, the desire for quality and price sensitivity, are often at odds with one another. The highest quality companies tend to come with the highest priced stock. After all, we are not the only ones who recognize quality. However, the stock of these high-quality companies tends to drop right along with everything else when the market sells off. In fact, these companies will frequently lead the sell-off; they are the easiest to sell, and professional investors being forced to sell often sell what’s easiest first.
This creates a classic baby-out-with-the-bathwater scenario. Market selloffs are the best time to selectively and prudently go shopping. Prudent investors use these opportunities to buy the stock of companies whose prices are usually too high for their taste. This is different than just blindly doubling down, as the gamblers would say. There must be careful analysis done to assure that these companies and their business are as strong as thought. One also has to be careful not to get too excited too soon. Selloffs can last longer than expected, and it is difficult to know when they are over. Prudent investors will buy little by little, building their investment over time. Downturns are opportunities.
Ok, I know what you are thinking: This is great for those people who have a long-term horizon, but what about the investor nearing or already in retirement? When one gets into this phase of her investing life, the goal changes from growing assets to producing income. With our retirees we run an income-oriented strategy, which can be complicated to pull off but is very simple in concept. We want to produce the income needed through actual income payments while taking the least amount of risk possible. The importance of this strategy comes to light when markets go down.
Bonds are the typical example of income-producing investments. Bonds are simply loans, and the interest payments on those loans represent income to the bond-holder. Many types of stocks also produce income through dividend payments. These income payments are often referred to as a percentage yield, but they are promised dollar amounts. They remain constant as long as the business itself remains sound.
When a market downturn occurs, a portfolio using this strategy will drop in value. The income strategy, however, will continue to produce the same amount of income, assuming we have done our job well in selecting safe companies. The values of these stocks will rebound over time, as will more growth-oriented investments; but more importantly, the needed income continues.
Many investors fret over the sudden market drop right before they retire. What happens if one was to retire in January of 2019? Everything looks great and then suddenly a bear market hits. All is not lost. If she follows our advice and builds an income-producing portfolio, the income yields have risen as stock prices dropped. If an investment worth $1,000 pays $50 per year in income and then drops in value by 20 percent (a full bear market drop), then that same $50 can now be produced with an $800 investment. In investment speak we say the yield went from 5 percent to 6.25 percent.
No one likes it when the market goes down instead of up, but it is the way investing works. We take three steps forward and two back. The secret is weathering the downturns well. The prudent investor doesn’t just sit there passively with his head buried in the sand; He uses it as an opportunity and deals with the actual circumstances at hand, for prudent investors know that no matter how one defines long term, that it is really just every short-term period added together. The ocean will be flat again after the storm has passed, but only the prudent skippers’ ships will still be afloat.
Chuck Osborne, CFA, Managing Director
~Time Keeps on Ticking
Socialism is supposedly more popular with people under the age of 30 than capitalism. Have you heard that? There are several such polls around. The question I have for those who make such claims is very simple: Can any of those respondents define those two terms? I have my doubts.
For most of my adult life, this conversation was not necessary. 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.
I had not heard anyone even try to argue against capitalism since Bill Clinton declared the age of big government over in 1992. Then, the financial crisis hit a decade ago. We started getting bank failures, and the anti-capitalism crowd was magically brought back to life. The actual crisis was caused, as all true crises are, by a confluence of things all happening at once. This, by definition, is complicated. I tell my children this all the time, especially my son: complicated things are just combinations of several simple things. Break it down into pieces and everything becomes simple, but the whole is complex.
The long-lost big government/anti-capitalism crowd, however, had a very simple one-word explanation for the whole thing: greed. Greed caused the crisis. 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, 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 simpleton’s 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 that 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.
Capital requirements, which were way too low, were set by regulators. The entire sub-prime mortgage market – the source of the crisis – was created by regulatory requirements. Ultimately what caused actual failures were the investments that the banks had made with their reserves, and again, what they were allowed to invest in was determined by regulation. Yet somehow this idea of “unregulatedness” caught on, while the regulators who were supposed to be providing oversight got rewarded with more power.
This idea has somehow remained. Just in the last year I had a conversation with an individual about the sad state of our healthcare system and the high price of drugs. He told me without hesitation that it was because the pharmaceutical companies were unregulated. My mouth dropped. Then I asked him what he thought the FDA did? It is regulation that grants these companies monopolies on their breakthroughs. Yet today any industry that is unpopular is evidently “unregulated.” That word must not mean what I think it means, because the truth is the most-hated companies in America are always in the most regulated industries. Therefore, for those who keep using the word, it must not mean free of regulation.
This misinformed idea magically overnight brought back some sort of legitimacy for the word socialism. I suspect, since these supporters do not know what unregulated means, they probably don’t actually know what socialism means. Socialism is an economic system under which the government owns the means of production. The first thing to understand about socialism is that it is not, as many believe, a political theory or system. It is an economic system. Some would believe that the two cannot be separated, but that is not correct and it is very important in actually understanding socialism. Socialism’s opposite is capitalism, which is also an economic system. Socialism is usually associated with totalitarian political systems, and capitalism is associated with democratic political systems. However, there have been democratic countries who have experimented with socialism, and both the Soviet Union (in its infancy) and currently China have experimented with capitalism.
Many may be familiar with Friedrich Hayek’s most famous book, “The Road to Serfdom.” Hayek argues in the book that economic freedom is a necessary element of political freedom. (If I were king for a day this book would be mandatory reading for all high school students in America, but that is another issue.) The book was inspired by Hayek’s life experience. As an Austrian he watched Germany embrace socialism, and he understood the role this played in allowing the Nazis to establish complete control over the country. Yes, you read that correctly: The economic system in Nazi Germany was socialism. Socialism is the natural economic system of any totalitarian form of government. The official name of the Nazi party was the National Socialist German Workers Party. I know this seems strange to the modern- day, capitalist-hating young socialist to whom anyone he does not like is automatically compared to Hitler, but when it came to economics, Hitler was a socialist.
As was Stalin. The two may have been on opposite sides of the political spectrum, but from an economic standpoint, the only difference between fascism and communism is who the tyrants are. Tyranny is tyranny, and socialism is tyranny. When I was a young economics student we referred to capitalism and socialism as simply a free economy versus a command economy. These titles are perhaps more clear. Do we want an economy where we are each free to act as we desire, or do we wish to be commanded by some authority?
To me, the answer to that question is as self-evident today as it was when our founding fathers found it to be self-evident. Liberty is our defining quality as a country, or it has been. Today many are asking for our freedom to be reduced. On college campuses there are actual arguments about limiting the freedom of speech. Thankfully most advocates for such are losing, but that it is even dreamed of in this country is more than a little scary.
Of course, it is only the other person’s speech that they wish to silence. Isn’t that always the case? There is no doubt that the best political system would be a monarchy…as long as I get to be king. Similarly, socialism is great if you are part of the ruling elite who get to tell everyone else what to do. Unfortunately, that isn’t how it works. Hayek’s most powerful realization was that given human nature, when you place that much power in government, the type of person who becomes attracted to wielding that power is usually some flavor of tyrant. As they say, power corrupts and absolute power corrupts absolutely.
But what about the less fortunate? 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. I mean read as in word for word, not the Reader’s Digest version which made Hayek a household name. 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.
John Maynard Keynes is another famous economist who is often thought to be on the opposite side of most issues from Friedman and Hayek. This is because he endorsed government intervention in the economy in an effort to soften the blows of recessions. While that is true, what is often lost is the motive behind this intervention. Keynes feared that if government did not step in to thwart some crisis, then the day would come when people would begin to abandon capitalism altogether. He wanted to save capitalism, not replace it. Keynes and Friedman did disagree, but not on the superiority of capitalism: Keynes thought government should stimulate the economy through fiscal policy, while Friedman thought monetary policy was superior. In truth their differences a far more about nuance than anything fundamental. It is the politicians who possess a bumper-sticker understanding of economics that create this supposed divide.
Keynes did speak more about income redistribution. However, it is important to understand that Friedman addressed inequality in his book “Capitalism and Freedom,” which was published in 1962. His work at that time showed a direct relationship between inequality and regulation. This makes sense if one thinks about it: the more things are controlled by the government, the more one has to know how to work the system. In other words, regulation rigs the system; in fact, it is the only way to rig a system. Rigged systems prevent social mobility, and economists today have shown that there is a link between social mobility and more equality overall.
Freedom works. Why is this so hard for us to understand? It is in our nature to want to control, to believe that someone has to be in control. This theme runs through every ancient religion, and overcoming that desire to control is central to all of them. 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. Hopefully, all those under-30 year-olds who think they want to try socialism will come to realize that before they actually lose their freedom.
Chuck Osborne, CFA, Managing Director