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.
This is a time for active management. It is a time when it is critical to understand what we own, and what is happening to those businesses.
Fear defined us in 2008, and just like the wise master counseled a long time ago in a galaxy far far away,
fear has led to anger.
Lehman Brothers is no more. AIG has become a ward of the state. There are no longer any big independent
Wall Street investment banks. The market has crashed. Madoff stole a record $50 billion. Etc.
Like Democracy, capitalism is not perfect, but it is the best system we have.
Who is to blame for $140 oil?
“YET EACH OF US DEFINES THE LONG RUN WITH A DIFFERENT TIME SPAN IN MIND, WHICH MEANS THAT YOURS WILL BE APPROPRIATE FOR ME ONLY BY COINCIDENCE. NO MATTER HOW WE FIGURE IT, THE LONG RUN MEANS MORE THAN SHUTTING YOUR EYES AND HOPING THAT SOME GREAT TIDAL FORCE WILL BRING YOUR SHIPS HOME SAFE, SOUND, AND LADEN WITH JUST THE RIGHT MERCHANDISE FOR THE OCCASION.” ~ Peter L. Bernstein
The investment world lost one if its shining stars this quarter with the passing of Peter Bernstein in June at the age of 90. The author of numerous books on economics and investing, most notably Against the Gods: The Remarkable Story of Risk, and founder of The Journal of Portfolio Management, Bernstein certainly belongs in the investing hall of fame. He spoke often about the misunderstood concept of long-term investing. He wrote: “The long run smooths the data by averaging out the wild volatility we experience in the short run. Therein lies its fascination. But therein also lies a mass of wishful thinking and oversimplification.”
Wall Street is broken – I believe we have made that point clear in our last two newsletters – but, what now? How do we get back to where we were and then on from there?
The first step is to understand the wisdom of Michael Price, legendary investor and founder of the Mutual Shares family of mutual funds, who said, “Wall Street is in the business of generating fees for Wall Street. Period. It is not in the business of getting good investment results. You have to separate from Wall Street to do that.” Wall Street also has dominated the communication to and education of the average investor over the last twenty years or more. That education is primarily marketing and while not un-true, it is filled with a mass of wishful thinking and oversimplification. Let’s debunk some of those oversimplifications.
I HAVE NOT ACTUALLY LOST MONEY UNTIL I SELL. This idea has become so ingrained in investor behavior that psychologists have created a name for it: the ‘break-even effect.’ People hate to admit a mistake, and holding onto losers until the value comes back makes one feel as if nothing was ever lost. We saw this in our clients last year and earlier this year as many questioned why we were reallocating their accounts, causing them to realize losses. We hear this from prospective clients, who wish they had been with us last year but don’t want to move until they have regained at least some of their losses.
This doesn’t impact just the lay person; many professionals fall into the same trap. In his book Your Money and Your Brain, Jason Zweig cites a study of mutual funds that got new managers. Researchers ranked the funds’ holdings from the best to worst return. On average, the new manager sold 100% of the worst-ranked securities, which implies the old manager was paralyzed by his own mistakes. The funds that cling most desperately to their losers underperform by up to five percentage points annually.
When Warren Buffett was a young man he spent a lot of time at the race track. On one particular day he lost money in the first race, so he decided to double down on the second race. He lost again. The trend continued all day until he had lost all of his money. The lesson he learned, which he says he still uses to this day, is that you don’t have to make it back the same way you lost it.
This does not mean you should simply sell out any time a price goes down – that would be another oversimplification. Sometimes a price drop is an opportunity, while other times it simply means what you own is not worth what you thought. The wise investor must be able to discern the difference.
ONE SHOULD SIMPLY “BUY AND HOLD.” This is the fallacy that Bernstein was debunking in the quotes cited earlier. Investing for the long term is, in our opinion, the correct way to invest. In the history of the market there is not one credible account of anyone who has been successful at rapidly trading in and out of positions for any prolonged period of time. That is not from a lack of data. Countless people fall for the allure of thinking they can beat the market by various timing strategies, but this is a loser’s game. It is wiser to invest for the long term. Warren Buffett once said, “Don’t own a stock for ten minutes if you don’t intend to own it for ten years.” This is a principle that we adhere to at Iron Capital.
Nevertheless, just because you intend to own a stock for ten years when you first buy it does not mean you should bury it in the back yard and forget it. I will bet my home that Warren Buffett would sell a stock two days after he bought it if someone came along and offered far more than Buffett thought it was worth, or if some new information came out that forced him to question the original decision. There does come a time to sell.
ASSET ALLOCATION DETERMINES RETURNS is another favorite oversimplification. People who promote this idea often quote a study by Brinson, Hood and Beebower, published in 1986, which examined 91 pension plans and concluded that asset allocation decisions determine more than 90% of the variability of returns. Financial advisers love this study and oversimplify it to the point that they will tell clients that it really doesn’t matter what funds you use… therefore those C-class shares that pay them handsomely are just as good as lower-cost, better-performing options.
Asset allocation, or more broadly portfolio construction, is indeed hugely important. The level of importance, however, is dependent on how you invest in the various assets. As David Sewensen, chief investment officer of Yale’s endowment, states in Pioneering Portfolio Management, asset allocation is the most important factor in the performance of large institutional portfolios largely because they have chosen to make it so. Most institutions use several managers per asset class and they prefer managers who don’t stray too far from their index. Those constraints greatly limit any value an active manager could add, therefore any value added must come from asset allocation. The smaller and therefore more concentrated your portfolio, the more important security selection becomes.
With all the talk in the investment world about portfolio construction, it is shocking to me how few practitioners actually understand how to build a portfolio. This is without a doubt the number-one flaw we see in portfolios we inherit from other advisers. I can only recall one prospective client who has ever come to us with a portfolio that had a coherent strategy evident in its construction. Although the strategy was different than ours at the time, I told the prospective client that he had an adviser who obviously knew what he was doing and that he should stay with him.
Usually what we see is a hodge podge of funds, stocks and ETFs, with no coherent theme whatsoever. It is what a former colleague of mine used to call ‘the front page Wall Street Journal approach,’ because it looks like the investor got up every morning and put money in whatever happened to be on the front page of the paper that day.
So how do you construct a portfolio? The basic premise is simple. At any given time you want to have the most money in the area of the market that has the highest probability of performing well going forward. You must, however, balance that with the risk that you could be wrong, so diversify with investments that all have promise but are unrelated to one another.
So what does that mean for today? We must understand the world we are in, and realize that this is most probably not the world that we wish it to be. Focus on quality, as this economy is a long way from recovery and many weak companies are yet to fail. Realize that government intervention is here to stay for the foreseeable future. Vote how you will, but do not fight Washington with your portfolio – you cannot win that battle. Also understand that Washington’s backing may guarantee survival, but it does not guarantee success. Be wary of unproven industries propped up by their political popularity, since such popularity can change quickly. Realize that the world does not revolve around the U.S. and that while the last century was certainly ours, the odds are that this one will not be.
This is a time for active management. It is a time when it is critical to understand what we own, and what is happening to those businesses. We must be able to recognize the difference between short-term market volatility and actual deterioration of a security’s real value.
We are entering a period where the broad market may go nowhere as the broader economy goes nowhere, yet there will be clear winners and losers. We are entering a period where portfolio construction will really matter, and those who understand that should do well, but those who simply close their eyes and hope that some great tidal force will bring their ship home safe, sound, and laden with just the right merchandise for the occasion will most likely be very disappointed.
CHUCK OSBORNE, CFA, Managing Director
~Where Do We Go From Here?
The great philosopher and leader of the Jedi Knights, Yoda, nailed it. Last year was defined by fear – fear in the mortgage market that led to fear in the bond market that led to fear in the stock market that led to fear in the real economy. Fear defined us in 2008, and just like the wise master counseled a long time ago in a galaxy far far away, fear has led to anger.
We are mad and we aren’t going to take it anymore. In many respects this anger is justified. It is righteous anger at the audacity of those who got us into this mess. However, there are two major issues with this anger. First, anger does lead to hate, which does lead to suffering, and most of the time that suffering is done by those who are angry, not by those on whom the anger is focused. Anger eats one up inside and leads to irrational decisions that are not necessarily in anyone’s best interest.
Secondly, and perhaps more importantly in this case, much of the anger is mistakenly aimed at “the rich” as an entire class, and at capitalism itself. The anger was intensified by bonuses paid to employees of firms such as AIG and Merrill Lynch, and most recently Freddie Mac and Fannie Mae. People certainly have a right to be mad. These were the very organizations that led us down this destructive path. But the anger is not stopping there. People are angry that some people get large bonuses period, and they are blaming it all on capitalism.
What they don’t understand, and to a certain extent what the people who got us into this mess didn’t understand, is that Wall Street is not capitalism, and the free market is not the stock market. Living in a free-market capitalist society on a daily basis has more to do with the grocery market than the stock market.
Free-market capitalism is about your right to shop where you want to shop or work where you want to work. If you want to start your own business, you can, since you are free. Companies are free to compete and consumers are free to choose.
Wall Street, or more correctly the capital market, is not the “system;” rather, it is a helper to the system. We seem to have lost track of that reality. Twenty years ago, Wall Street consisted of mostly independent firms who were focused on raising capital for successful businesses or managing investments. Internally we referred to the two sides of Wall Street as the “sell side” and the “buy side.” The sell side was made up of investment banks and broker-dealers that focused on helping companies grow by providing access to capital through the stock and bond markets. The buy side was made up of investment advisory firms that helped institutions, such as pension funds, and individuals buy stocks and bonds for investment purposes. The two sides were completely separate and combined represented less than 18% of the total corporate profits of the US. Most of these firms were partnerships, not publicly traded companies, and the risks they took were borne directly by the partners and clients.
Today, these lines have been blurred. Most Wall Street firms are publicly traded companies whose risks are borne by the shareholders and clients, not by management. They have grown to represent 41% of the US corporate profits as of the end of 2007. They are in all sides of the business even though this represents huge conflicts of interest. They are no longer interested in helping companies or in helping investors. Their only interest is in manufacturing products that are profitable to them.
One amazing aspect of the financial services industry is that they were seemingly able to create their own demand for any product they wished to push. At the beginning of this decade, I was still at Invesco. AIM, Invesco’s mutual fund division, was introducing separately managed accounts. These were mutual funds without the funds. Clients would get their own accounts with all the underlying securities that were in the mutual fund, for over double the price of the mutual fund. I asked why we were doing this, because it seemed insane to me that anyone would pay more than double for what is essentially the same thing. I was told that there was “huge client demand.”
I have never been one to simply believe what I am told, so I did some investigating and began asking people who had invested in these products why they did it. Every single time, I was told that they did it because that is what their broker recommended. I even had some people ask me, “Why is my broker ’pushing‘ these accounts?” Granted my investigation falls short of a true scientific survey, but I will bet the farm that there was zero true client demand for so-called separately managed accounts. The demand was created by the Wall Street firms themselves.
Why the firms wanted these instruments is obvious – they get the lion’s share of the fees, and more importantly, 100% of the trades. Clients don’t balk because these trades are “commission-free.” What clients don’t understand is that commissions are just the beginning of trading costs that go to the Wall Street firm. The only reason someone would invest in these products is to make more money for the Wall Street firm.
The firm tells their brokers to push this product, and they do what they’re told. Clients believe their brokers are “advisers” with only their best interest at heart, so they agree. How do these people sleep at night? They are protected by layers. The money managers never meet the clients. Many firms have even created a position called “client portfolio manager” who poses as the money manager if larger clients insist on meeting someone, but they are not actually the manager. Most money managers don’t care to meet the client and rarely give the client a thought, because they are doing what they love, getting paid well for it, and dealing with the client’s best interest is someone else’s responsibility. That responsibility falls on the shoulders of the broker, but the brokers aren’t investment professionals and don’t know anything about investing that they have not been told by their bosses, who are telling them to push this product.
Nowhere has this pattern been clearer than in the explosion of “alternative investments.” The argument goes that an investor should diversify away from stocks and bonds. They should invest in commodities, emerging market stocks, and – always included in the list – hedge funds. We are told that hedge funds are very risky, so we should not invest in just one hedge fund, but in a fund that invests in other funds. So the investor goes to an adviser who recommends a hedge fund “fund of funds” because that is the latest craze. The manager of the fund of funds gets paid a fee, the actual hedge fund managers get paid a fee, and the broker gets paid a fee. The only person who doesn’t make out in this deal is the investor, whose profits are eroded by everyone else’s fees.
The defenders of these strategies will say they are emulating the huge success of college endowment managers at places like Harvard and Yale. Unfortunately for them, David Swensen, the Chief Investment Officer at Yale, calls the fund of funds a “cancer.” Warren Buffett has made a well-publicized bet that one of the largest of these fund of funds will not be able to beat the S&P 500. These legendary investors understand that one simply cannot overcome the layers of fees.
These layers explain why Wall Street has gone from 18% to 41% of the US economy. They exemplify what is wrong with Wall Street and why people are so angry. Americans are not angry simply because some people got rich over the last 20 years; they are angry because they got rich by ripping people off instead of by building real companies that provide valuable products and create jobs that enrich others.
We must get back to the basics. Wall Street needs to focus once again on helping companies access capital to grow, and on helping investors invest in those companies. We must provide investors with direct access to expert investment counsel. The only way that will happen is if investors refuse to do business with the retail arms of the big Wall Street firms. If you are angry about what has happened, then take action and close any accounts you have with Wall Street firms. Then let your anger go before it does turn to hate and then to suffering, because the suffering most likely will be your own.
CHUCK OSBORNE, CFA, Managing Director
AIG has become a ward of the state. There are no longer any big independent Wall Street investment banks. The market has crashed. Madoff stole a record $50 billion. Etc. If the historical events of 2008 have taught us anything, they have taught us that Wall Street is broken. The natural questions are: what went wrong, and how do we fix it?
The most common response to the first question is simply greed. However, I don’t believe greed is the problem. For those who now expect me to echo the sentiment of Gordon Gekko (Michael Douglas’ character from the movie “Wall Street”) and say that greed is good, I hate to disappoint. Greed is not good in my opinion. The problem with simply saying the cause of this crisis was that people on Wall Street were greedy is that in order for that to be true, either there must have been a time when people on Wall Street were not greedy, or there has actually never been a time when Wall Street has worked. I seriously doubt there is anyone who would argue the former, and while there are probably some extremists who would argue the latter, the evidence against this argument is overwhelming.
I have thought long and hard on this issue, and greed, while certainly a factor, just didn’t seem to fully explain this crisis. Something was missing. The words of an old mentor kept coming back to me. In large complex organizations, the vast majority of problems are caused by structural issues, not human fallibility. Wall Street is structurally broken, and it is going to take more than a spiritual revival to fix it.
To understand why Wall Street is broken, you must first understand why Wall Street exists in the first place. What is Wall Street’s purpose? Wall Street exists to bring together people with business ideas with people who have capital to invest. This is the essence of capitalism: Investors decide what companies will be provided the capital they need based on the merits of their business plans, not on some central plan devised by government leaders or on political connections. Capital is free to flow to the best business ideas. These companies use that capital to build plants, to create products that people actually want to buy, and to create jobs and prosperity.
For all of its history, Wall Street and the investment banking firms that had come to represent it have financed American industry. The railroads, steel, oil, automobiles, computers, and the Internet were all financed by Wall Street – real industries made up of real companies that produced real products and real jobs. The business managers would come to Wall Street with their ideas and plans, and the investment banks would underwrite loans in the form of bonds, or ownership stakes in the form of stock. The investment banks would take those stocks and bonds and distribute them to investors through their brokerage offices around the country. These investment banks made money by charging fees to the companies they helped and by charging commissions on all the stocks and bonds they sold to investors around the country.
Then something happened starting in the 1980s. Technology along with advent of the discount broker started putting pressure on all those commissions. It became more and more difficult for the big Wall Street firms to charge those high commissions on simple stock and bond transactions. At the same time the work of Harry Markowitz, the founder of modern portfolio theory, was becoming more accepted, and the concept of risk management was becoming popular in the investing world. Everything you know about diversification, risk and return all came from the work of Markowitz.
This desire for diversification, along with the introduction of the 401(k) plan, helped launch the mutual fund industry.
Here is where it is important to understand how “investment education” for the masses gets disseminated. For Wall Street to push a concept, it must be generally correct (they would not be so foolish as to push out and out lies), but it also must be profitable to Wall Street. Mutual funds were very profitable. All of a sudden the average client who might invest in ten to twenty stocks and bonds could be sold a mutual fund instead. The fund invested in hundreds of stocks and bonds. And guess what, the mutual funds buy and sell stocks and bonds the same way anyone else buys and sells stocks and bonds – through Wall Street brokerages. Sure, they pay lower institutional commission rates, but they make up for that in volume and also tend to trade far more often than the average investor.
But that is just the revenue that happens behind the scenes. On top of all that, the Wall Street brokerages still got commissions from selling the funds themselves, and they got a piece of the ongoing management fees. As brokers started shifting away from selling individual stocks and bonds towards selling funds, they had to come up with new ways of explaining their purpose, i.e. “adding value.” After all, picking funds didn’t seem nearly as hard as identifying a lucrative stock, especially early on when there were not as many funds out there. So they became “advisers.” That is when Wall Street really embraced Mr. Markowitz and his theory. Owning one mutual fund is not enough; one must own several funds that invest in different types of investments.
Now the average client, instead of buying ten to twenty stocks and bonds – ten to twenty transactions for Wall Street, or one hundred stocks and bonds in one fund – one hundred transactions for Wall Street, can own thousands of stocks and bonds – thousands of transactions. Plus the fees, oh the fees – how wondrous were the fees!!
Over the years as the mutual fund industry matured, fees became more competitive and Wall Street firms could no longer make as much. To reduce costs, mutual fund managers became wiser about how they traded. Today that party is over and an investor can find low cost mutual funds that make sense. But, Wall Street had learned its lesson. Selling products was much more profitable than just distributing stocks and bonds.
Next came the so-called separately managed account. You could have the mutual fund manager manage your money without the mutual fund. Now all the underlying stocks and bonds were custodied with your brokerage firm and you could see them on your statement if you wish. In addition, your brokerage firm got a much bigger piece of the management fee, which – because these were “custom” – was 2.00% to 3.00% instead of 0.50% to 1.00%. Wall Street had figured out how they could create a mutual fund where they got more of the money than the mutual fund manager.
By now we were in the 21st century and the market had started to come down from its twenty-year run through the 1980s and 1990s. Hedge funds, however, were making money. Up until now these had been little-used and talked-about instruments for the rich. But, hedge funds were able to sell short, and when the market is heading down, selling short seems like a good idea. In addition, these funds were even better than separately managed accounts because they used margin. Wall Street makes a lot of money off of investors who use margin, because the investors have to pay interest on that margin. They also make bigger transactions – higher commissions, and they sell short – higher commissions still. On top of all of that, hedge fund managers trade even more frequently than mutual fund managers – once again, higher commissions.
All of that money is made by Wall Street before the hedge fund even charges the client their fee. Because these instruments are so “sophisticated,” charging the 2.00% to 3.00% you would pay for a separately managed account is simply not enough. They must charge 2.00% plus 20% of any gains.
Wall Street lost sight of its true purpose, and instead of simply providing capital to business managers, they started creating products. The more complicated they made them, the more profitable they became. They could turn anything into a product. Mortgages? No problem – securitize them. They don’t pay enough? No problem – add some leverage. Risk? We will create products that spread the risk to multiple counterparties.
Oh, by the way, those counterparties all have to get paid too, but that is alright – what goes around will come around, we are all in this together. Right up to the point when it implodes.
Some have said the crisis of 2008 is a failure of the capitalist system. I wanted to check it out, so I went directly to the source: the capitalist bible, Adam Smith’s The Wealth of Nations. It had been a long time since I had read it, but I did not recall the chapter on Collateralized Debt Obligations. I had no recollection of Mr. Smith’s view of Credit Default Swaps, or even simple Mortgaged Backed Securities. When I picked the book back up I discovered why I had no recollection of these things. They are not there. Capitalism is not about complicated financial products. It is about the ownership of companies. Capitalism isn’t represented by Wall Street or hedge fund managers; it is best represented by small business owners – real people with ideas who want to create something real.
Wall Street is broken. To fix it, we must get back to basics. We must move away from buying its products and playing the market, and get back to investing in companies – real companies that produce real products and create real jobs.
CHUCK OSBORNE, CFA, Managing Director
~What’s Wrong with Wall Street?
We are thankfully coming to the end of what has been the longest, and in my opinion the least substantive, presidential race in American history. Oh, we all know who the latest internet poll says is winning, but can anyone accurately describe either candidate’s platform? On August 25 of this year the Wall Street Journal reported on a Pew Research poll which recently discovered that, for the first time, more than 50% of Americans knew that the Democrats have been in control of Congress. If our media have failed to relay this basic fact to the American people, how well do you think they have done in educating people on the nuances of the candidates’ economic policies?
Okay, I know what you are thinking, is Chuck actually going to talk about politics? We try to avoid such subjects at Iron Capital, as we advise clients of all political persuasions and of course do not want to offend anyone. However, in the midst of what may be the worst financial crisis in our country’s history, we think we owe it to our clients to weigh in on economic policy. After all, it has a direct impact on your wallet and is our area of expertise. I make you two promises during this foray into politics: I will stick to economics, and to avoid showing favoritism, I will make sure that I offend everybody.
I will begin the offending process by stating a disturbing fact to the most partisan. While there are plenty of subjects for Democrats and Republicans to disagree on, the basic framework of economic policy should not be one of them.
Earlier this year, the University of Chicago launched a $200 million academic enterprise called the Milton Friedman Institute, named after the famous economist and Nobel laureate who spent the bulk of his career on staff at the school. The effort was attacked by many on the faculty in other departments, most notably by Bruce Lincoln, a professor of the history of religion. The reason for the backlash was a statement made by the institute that it would “reflect the traditions of the Chicago School and typify some of Milton Friedman’s most interesting academic work, including his…advocacy for market alternatives to ill-conceived policy initiatives.”
Professor Lincoln is upset that the University of Chicago could make such a statement as if it has been proven that the free market is superior to government intervention. After all, the battle between free market capitalism and socialism / communism constituted much of 20th-century politics. Lincoln seems surprised to learn that this argument is over. Evidently there has been some confusion as to why Friedman won the Nobel Prize.
Milton Friedman won the Nobel Prize in 1976 because he and his esteemed colleagues from the University of Chicago (from which there have been 25 Nobel Prize winners in economics) transformed economics from a soft social science to positive science. They introduced quantitative analysis of their theories. Friedman defined the Chicago School of Economics as “an approach that insists on the empirical testing of theoretical generalizations and that rejects alike facts without theory and theory without facts.” Friedman actually believed in government intervention in the economy, until the empirical evidence from his research proved otherwise.
What Friedman learned, which surprised him, was that the less involved the government was, the freer the market, and the better off the society as a whole. Particularly surprising, and something that still goes against conventional wisdom, was the fact that the middle class in particular was better off in a free market. In fact, the middle class is a free market phenomenon. The more government is involved, the more you have only two classes of people – the ruling elite and everyone else. This is not an opinion, it is empirical truth. Once you have sailed around the world, arguing that it is flat doesn’t make sense.
Now this is when my Democrat friends will tell me that I’m just spewing Republican propaganda and if any of this is true, then how do you explain this crisis?
When Democrats blame “Bush’s failed policies” for the current crisis, they often follow it up by the political stereotype of Republicans. They say Bush was in love with the free market and deregulation. They fail to remember the lesson that can be found in one of my favorite political movies, Charlie Wilson’s War. Joanne Herring, the socialite played by Julia Roberts, asked Charlie why Congress was busy saying one thing while doing nothing, to which Charlie responded, “Well, tradition mostly.” When it comes to politicians, it is a good idea to take the advice often given to young girls about boys: pay attention to what they do, not what they say.
The problem with the argument that deregulation caused this crisis is that there has not been one act of deregulation in the entire eight years Bush has been in office. The fact is that Bill Clinton, whose political stereotype would be of a pro-government regulator, actually reduced the size of government and passed significant deregulation. As a result the economy grew under his watch and most Americans prospered. The only regulatory accomplishment of the Bush administration has been Sarbanes-Oxley, which has no direct relation to our current problems, but was arguably the single largest increase in regulation since the Great Depression. This crisis has been caused by Bush’s failed policies, but those policies have been to grow government and increase regulation.
Once government interference starts, it is like being on a drug. It makes you feel good at first, but then the crash occurs. A rational mind would say, “I must get off this drug because it makes me feel so bad,” but that isn’t what the drug addict thinks. He thinks he needs even more, and the destructive cycle begins. You regulate an industry, so they become incented to get friendly politicians elected. The industry contributes large sums to campaigns, and politicians rig regulation to help their financial backers. While some regulation is obviously needed, we must remain mindful that regulation often leads to corruption.
This same cycle is evident in what has really happened in our current crisis. The federal government many years ago made encouragement of home ownership national policy. They created Freddie Mac and Fannie Mae to back mortgages made to lower-and middle-class Americans. This worked great at first, as more and more Americans were able to buy homes. Then these government agencies started donating hundreds of thousands of dollars to the very politicians who were supposed to be policing them. In return for their generous gifts, there was more and more encouragement of creating mortgages for anyone who wanted one, whether they could qualify or not.
This created a distortion in the free market. The perceived risk of lending to so-called subprime home buyers was reduced because of the inherent government backing – banks knew they would be bailed out if it went wrong, so why not do it. This was only compounded by the evolution of securitization, which allowed banks to sell their mortgages in bundles to further reduce the risk.
Bubbles occur when markets get distorted, and when a bubble explodes, we have a crisis. This crisis was caused primarily by the drug of government interference in the marketplace, which led to corruption. The rational solution would be less government involvement in the mortgage market, and better, not more, regulatory oversight. However, the knee-jerk reaction is simply more regulation, which will once again make us feel better in the short-term, but will lead only to misery down the road.
We have a very important choice to make when we go to the polls in November. It will determine in a large part whether we do the wise thing in response to this crisis, or do the emotional thing and make things worse. Milton Friedman and his fellow economists have proved that the empirical evidence for free market capitalism is overwhelming. Like Democracy, capitalism is not perfect, but it is the best system we have. Crises like the one we are in now are almost always caused not by truly free markets but by market distortions caused by government involvement.
So which candidate understands this, and would be better economically? The only advice we can give is to vote how your heart leads you, but do so not based on what politicians say in their speeches, but based on what they have actually done in their careers. Remember the “Liberal Democrat” Bill Clinton reduced government, balanced the budget and gave us eight years of economic growth, while the “Conservative Republican” George W. Bush has grown government, increased regulation, and given us the worst economic crisis in generations. If the economy is your issue, vote for the candidate who has a track record of actually trying to reduce government and create better, not more, regulation. Remember Charlie Wilson’s warning. Saying one thing and doing another is a tradition in Washington. Don’t pay attention to speeches, pay attention to what candidates have actually done.
CHUCK OSBORNE, CFA, Managing Director
~The Politics of Economics
“Come and listen to a story ’bout a man named Jed, poor mountaineer barely kept his family fed. Then one day he was shootin’ at some food, and up from the ground come a bubbling crude. Oil that is. Black gold, Texas tea.”
~ The Ballad of Jed Clampett ~
If they were ever going to bring back “The Beverly Hillbillies,” now would be the time. Not only is that Texas tea in Jed’s backyard worth approximately five times what it was worth in 2002, but that mansion in Beverly (Hills, that is) can be purchased for a good 20% discount off the housing boom highs. Jethro could have the biggest cement pond you have ever seen, and Granny could have a proper distillery added to the house. Mr. Drysdale would be ecstatic, as Jed’s business alone might be enough to save his bank from the woes of sub-prime. Can you imagine a more timely show?
Unfortunately, this is not a television situation comedy. The housing slide continues and the credit crisis just seems to linger. However, the big star of this past quarter has been oil, so that will be our focus for this article.
Americans love nothing more than to play the blame game. Whose fault is it that oil is selling at over $140 per barrel? We want a simple solution, like the oil companies are just gouging us, or speculators are manipulating the market. The truth is not that simple, and unfortunately for those who would like to see “justice” done, there really aren’t any bad people pumping up the price of oil just to make our lives miserable, and no matter what your favorite politician promises, there are no quick fixes.
The first eight years of this new century have seen explosive growth in emerging countries, primarily in China and India. Along with that growth has come new-found wealth, and with this wealth, a good percentage of the approximately 2.5 billion people in China and India started trading in their bicycles for automobiles. The demand for oil consequently rose sharply, and as any first-year economics student can tell you, if the demand rises and supply stays the same, the price will go up. Economic theory would suggest that the higher price would cause people to cut back on consumption and would provide an incentive for suppliers to increase output, thereby causing demand to shrink, supply to grow, and the prices to fall back to norms.
Why hasn’t that happened? Let’s take supply first. There was an initial supply response, but supply seemed to peak in 2005 with total production of approximately 85 million barrels a day. There are a couple of reasons why supply has not grown faster. In our fast paced world we forget that getting oil out of the ground takes time, and six years is not a long time in the context of developing an oil field. The largest part of the price increase has been over the last nine to twelve months, and it simply isn’t reasonable to expect results that quickly. Based on capital expenditures of the large oil companies, they are working hard to find and get us more oil, but it doesn’t happen overnight.
In addition, oil is a non-renewable energy source. The world’s existing oil fields are in different stages of their production life, but as a whole, the existing sources are experiencing declines of approximately four percent per year. This means that the first 3.4 million barrels of new daily production simply replaces the depletion from existing wells.
These factors have played a role in the lack of response in the supply of oil, but what has kept demand so high? The reality is that cutting back on oil is not that easy. Sure there are things we can do. Couples with two cars can use the more efficient car as much as possible. We can all plan more carefully to consolidate our car trips and avoid wasted mileage. We can use public transportation and, of course, take better care of your car and check the tire pressure. All these tips can help your pocketbook and the environment, but not driving is not an option for most of us, nor is not heating your home.
The biggest reason there has not been a reduction in the demand side of the equation is because of government subsidies for oil. Fuel subsidies are widespread in emerging-market nations. Morgan Stanley estimates that half the world’s population enjoys fuel subsidies, and a quarter of the gasoline consumed worldwide is bought at less than market prices. Gas is five cents per liter in Venezuela, which is the cheapest price in the world. The Chinese pay $0.79 per liter, compared to Americans at $1.04 per liter and Germans at $2.35 per liter. Consumer demand in the emerging economies will not slow down unless the consumer is impacted by the higher prices.
This combination of increased demand and tight supply started the run-up in oil prices, but does it really explain $140 per barrel? Not by a long shot, according to Chicago-based market research firm Probability Analytics Research. They say that supply and demand account for a price of oil in the $60 to $75 range. The Saudi Arabian oil minister, Ali Al-Naimi, agrees with them and has suggested that the range should be $60 to $70. These estimates are considerably higher than what oil prices were in the last decade, but half the current price. So what is causing the difference?
Some have blamed the value of the dollar. Oil, like most global commodities, is priced in dollars and the value of the dollar has been falling. If the dollar is less valuable, then it will buy less oil, or so the argument goes. This is true to a point, but the dollar has not fallen nearly far enough to account for oil at $140 a barrel. So there must be something else.
Investors make up the difference, according to Mike Masters of Masters Capital Management, who notes that trading volume in oil futures markets has gone through the roof. For example, open interest in the West Texas Intermediate crude oil contract traded on the NYMEX (just one example on just one of several exchanges) has risen from less than 500,000 contracts in 2004 to more than 1.5 million contracts currently. Each contract represents 1,000 barrels of oil. Masters, in his testimony before a Senate sub-committee on May 20, 2008, estimated that the rise in investment interest has added an equivalent of 848 million barrels of oil to demand, roughly the same impact as increased demand from China.
To be fair, Masters’ view is controversial. There are many people who have come out and tried to dispute the idea that futures trading could have this impact. They argue that investors are buying futures contracts (which give the purchaser the right, but not the obligation, to buy oil at a given price some time in the future), not actual oil. This argument does not hold water, however, because the futures price and the actual price must converge as the contracts near expiration. Otherwise there would be an arbitrage opportunity, and the markets are far too efficient for that to happen. Others argue that for every speculator that is betting on oil going up there is another speculator betting on it going down, and they counteract each other. That would be true if this was about speculation, but it isn’t.
I myself got caught by that argument, but in reading the research it dawned on me that these new entrants into the oil futures market are not speculators at all – they are pension funds, who are buying and holding. This is all part of the “alternative investment” craze, which is a subject for a future newsletter. The bottom line is that pension funds in recent years have made commodities a permanent part of their portfolios. Masters may overestimate the impact, but his arguments are sound, and it defies logic to think that billions of dollars can be poured into commodity futures without having any impact on the market prices of those commodities.
So who is to blame for $140 oil? There is no one culprit, but rather a result of the confluence and culmination of several new realities of our global economy. Oil started to rise in price because of real fundamental economic principles of supply and demand, and it has kept going up because of investor interest. However, there is good news. Oil prices will fall. When? I can’t tell you, but it will happen. Demand is cracking. Airlines are cutting back, people are buying smaller, more efficient cars, and those emerging countries are beginning to lift those subsidies. Finally, supply eventually will increase as new exploration begins to pay off and alternative energy sources become more competitive.
We survived the 1970’s, and we will make it through these times as well. So as Jed and all his kin folk would say, “Y’all come back now, ya hear?”
CHUCK OSBORNE, CFA, Managing Director