We have just experienced one of the strangest quarters that I can remember. At the beginning of June, Goldman Sachs research indicated that all of the return for the S&P 500 year-to- date through May was attributed to just seven stocks; the other 493 stocks in the S&P 500 have an average return of zero, nada, zilch. How did that happen?

Let’s start with some history. We are going back all the way to 2022…which sounds silly in most conversations, but stock market participants are famous for their extraordinarily short memories. After a decade of technology stocks dominating all the returns in the stock market, the rest of the market finally got some revenge in 2022. Value investors outperformed their growth colleagues for the first time in a long time and the gap was large in the final quarter of 2022. The Russell 1000 Value Index was up 12.42 percent, while the Russell 1000 Growth Index was up only 2.2 percent.

The new year began with growth stocks making a comeback: In the firstquarter of 2023, the growth index was up
14.37 percent, with the value index up just 1.01 percent. At first this was just the normal back-and-forth of the markets. We often refer to a phenomenon known as reversion to the mean – meaning that stock investment results tend to move toward the long-term averages. If they get well above the average they tend to drop, and if they get too far below the averages, they tend to rise. That explains one good quarter for the growth stocks, but as we moved into the month of May, something else started to take over – something that is certainly artificial, but is it intelligent?

Time will tell as far as stock prices go, but there is no doubt that artificial intelligence (AI) has dominated the stock market in 2023. The poster child for this phenomenon has been Nvidia; the stock has risen 189 percent in 2023. Before we get too excited, remember one thing pundits never bring up: Nvidia stock went from $326.76 in November 2021 to $121.39 in September 2022. The stock is up approximately 30 percent from its high in late 2021, which is a solid two-year return, but not as exciting as the “up 200 percent” we hear about.

The rebound in Nvidia stock has to do with generative AI such as ChatGPT. These are computer algorithms that can create new content. It is a breakthrough in computer technology, and the long- term potential is tremendous. Experts in the field have suggested that AI will be bigger than the internet, and there is already fear of AI coming for all of our jobs. The machines will take over just like they did in “2001: A Space Odyssey,” or “The Terminator,” or “The Matrix,” or “I, Robot” … you understand, it has been a thing for a while now.

Nvidia is the leader in designing chips used in Graphic Processing Units (GPU), which are key to the computer power necessary for AI. Microsoft has also benefited as they are a leader in the cloud and have announced a partnership with OpenAI, the maker of ChatGPT. Additionally, some well-known tech companies have the potential to benefit: Meta (Facebook’s parent company), Alphabet (Google’s parent company), Amazon, Apple, and Tesla are all believed to be beneficiaries of AI’s potential. Combined with Nvidia, they have been dubbed the “Magnificent Seven.”

It is these seven stocks that have dominated the returns this year. They completely skew the valuation of the market and the market’s return, and it is these that pundits are really talking about when they ask if the market can continue to rally. Let’s address them specifically.

I am no technology expert, but I do know a little about how the market reacts to technological breakthroughs. The market response is a phenomenon called the Gartner Hype Cycle: It begins with a technological trigger – the breakthrough itself kicks things off. We then move to the peak of inflated expectations, and early publicity leads to grossly exaggerated claims of potential. Then, we enter the trough of disillusionment – technology has never adapted as quickly as the zealots believe it will, and when the fantastic predictions fail to immediately materialize, then bubbles burst and stocks plummet.

That leads to the slope of enlightenment: Technology has never adapted as quickly as zealots believe, but it has adapted faster than naysayers would suggest. People start to see realistic applications. These realistic applications eventually lead to the plateau of productivity, in which the new technology is being used to make our lives easier – not as first imagined, but in real ways nonetheless.

AI is currently in the peak of inflated expectations. Nvidia’s stock is selling at a price-to-earnings (P/E) ratio of 215, so a speculator in Nvidia’s stock is paying $215 for every $1 in earnings. That is not sustainable, but does that mean the market will come crashing down?

No, it does not. There are 493 stocks in the S&P 500 alone that have been neglected thus far in 2023. The excitement over AI is understandable, but it is only part of the market story thus far in 2023. The other part remains the insistence by many pundits that the recession they said would be here by now is just delayed, as opposed to them just being wrong. The theory goes that the never-arriving recession is right around the corner and therefore stocks will get beat up, so let’s get ahead of it and beat them up now…except for the Magnificent Seven, because with the power of AI these companies will be able to grow regardless of what is happening in the economy. That is true and was certainly the case in the aftermath of the Great Recession. Then it was the FANG stocks (Facebook, Amazon, Netflix, and Google) that held up the market. However, the idea that we are heading into a recession today has thus far been wrong. At some point, reasonable people must admit their mistake.

Let’s play devil’s advocate just for a second: Let us pretend that the people who have been saying we are heading into a recession for the last year and a half are actually correct, so the recession arrives and the AI companies are the only ones growing. So far so good, but what about the stocks that usually hold up in recessions? Defensive stocks like utilities? Duke Energy’s stock is down 13 percent year to date. This makes no sense for two reasons: First, utilities should hold up well in a recession, and secondly and perhaps more importantly, what do GPUs (graphic processing units), cloud computing, and electric cars all have in common, besides AI? They all use enormous amounts of electricity. What does Duke Energy sell? Oh yeah, electricity. In what world can Tesla and Nvidia thrive but utilities suffer? That world does not exist.

Maybe utilities shouldn’t have been beaten up like they have been this year, but when that recession we keep hearing about finally comes, stock valuations must come down. Fair enough, but the index valuations are now completely skewed by the Magnificent Seven. One of the ways Iron Capital looks at valuations is to compare the valuations of different asset classes, and then comparing them. The valuation spread, or difference, between domestic stocks and international stocks is currently at a two standard deviation level. In plain English – the difference between international stocks and domestic stocks is larger than it normally is by an unusual amount … so unusual that this happens less than 5 percent of the time. Nvidia may be selling at 215 times, but the French energy company Total Energies is selling at only 6 times. This is unbelievably inexpensive.

So, what does all this mean? It means the headline story of the first six months of 2023 is misleading. When pundits say the market is up, they are really only talking about seven stocks in the S&P 500. When they say it is expensive, they are really only talking about seven stocks. When they say it can’t continue, they are right – if they mean those seven stocks. The other 493, on the other hand, are poised to catch up.

We are optimistic about the rest of 2023, but it can’t look like the first half. First, the doomsayers need to admit they are wrong: We are not heading into a recession because interest rates are returning to normal levels. Second, AI may indeed be bigger than the internet one day, but that day is a lot farther away than the zealots believe…it is also closer than the naysayers might think, but it isn’t here yet.

Before this little detour into insanity, we saw the markets rotating to value, small and international. That remains the long-term trend, and one six-month tease doesn’t change it. That rotation has legs, and the power of both momentum and valuation. We just need patience. Prudent investing pays off in the long run, but it does require patience.

Warm regards,

Chuck Osborne, CFA
Managing Director

July 2023

~Artificial Distribution

“Are we heading into a recession?”

This is the number-one question I have been getting from clients recently. I answer with a question: How is your business? The answers vary, even inside the same company.

One of our long-term clients is primarily in the transportation business. They have other businesses as well, including a few very good restaurants, but their main business is helping goods get into our harbors, off of ships, and up rivers. They have several locations around the country, and we get to go to all of them. I shouldn’t say this on the record because now they will be on to me, but casual conversations with this client have an impact on our view of the economy. They are on the front line. I almost laugh when they ask for my view – I sit in an office reading reports. These folks are moving a significant portion of everything you buy. They will know long before I do whether the economy is slowing down.

Just a few weeks ago I was visiting their Norfolk, VA, location. Someone there asked me about the economy, and I replied by asking about their business. “We are busy,” was the response. Last year was a record year and they are expecting it to be just a little higher this year. That is an encouraging sign, but is it universal?

A few weeks before that visit I was talking to the same company’s CFO. When I asked him how business was going, his response was a little different. He said that when viewing potential mergers or acquisitions, they now had to factor in the cost of capital. In other words, higher interest rates mean that it will cost them more if they decide to purchase another company. That may mean fewer business deals this year. That isn’t encouraging.

Meanwhile, one of my colleagues visited the same client’s New Orleans location. When he asked how their business was going, they said it was good, but some of their clients are seeing a slowdown because they used to bring grain from Russia, which now isn’t happening because of the war in Ukraine. That is interesting.

The same client, yet three different takes on the economy. I have also gone on record saying that I believe the power of the Fed over the real economy is hugely overrated. I still believe that, and I still believe that Wall Street and economists in general remain overly pessimistic. How do we make sense of these mixed messages?

Albert Einstein famously said, “If you can’t explain it simply, you don’t understand it well enough.” I believe he is correct, but it goes further. Most experts can’t explain things clearly because they are more concerned with being considered an expert than communicating clearly to the everyday person. In other words, their egos get in the way. They insist on peppering their speech with jargon, or worse yet, acronyms. As a result, in my opinion, they often lose sight of the most basic fundamental understanding of what is actually happening.

The experts cite past data showing that when the Fed raises interest rates, the economy goes into a recession. They get so focused on analyzing data that they forget to ask the most fundamental questions: Why? What is really happening?

Raising interest rates impacts just one thing: the cost of borrowing money. That is what interest rates are – they are the cost of borrowing money. When one purchases a house, she usually borrows the money in the form of a mortgage. That mortgage, like all loans, has an interest rate tied to it, and the interest must be paid. The higher the interest rate, the higher the monthly payment.

However, that same consumer, if she is being responsible, doesn’t borrow money to buy groceries, clothes, or any other day-to-day item. Most of the goods we buy do not require loans, so interest rates don’t have an impact. Likewise, a company will usually borrow money to buy another company, to build a factory, or for any other major business investment. That same company hopefully does not borrow money to hire a new employee, pay their office lease, or any other routine business expense.

Those day-to-day items, which are paid for out of pocket, make up the bulk of economic activity. Roughly 70 percent of our gross domestic product (GDP) is made up of consumer spending. For consumers to spend, all they need is an income source, preferably a job. Companies mostly hire without borrowing and most consumer spending is done without borrowing, so the majority of the economy is not actually impacted by the Fed raising interest rates.

However, there are items that typically require borrowing, and these items will be impacted by higher interest rates. For the consumer, those are primarily automobiles and houses. For companies, the biggest items that require borrowing in our current economy would be other companies – mergers and acquisitions. One of the primary drivers of an individual company’s growth is its ability to purchase competitors and/or suppliers. Occasionally they will even purchase a completely unrelated business.

Mergers and acquisitions also fuel much of the financial universe. Investment bankers are the financial professionals who help negotiate and fund mergers and acquisitions. This is a large part of Wall Street’s business, and that is important to understand. Higher interest rates will make it more expensive to buy businesses, just like they make it more expensive to buy houses. That will result in fewer mergers and acquisitions.

How do fewer mergers and acquisitions impact the economy? Buying another company can be of significant benefit to the owners of both companies. The owners of the company being purchased get a big payday, and the owners of the purchaser now own a much larger company. What benefit is this to the economy as a whole? Very little, if any. Economic activity is measured by GDP, which is the gross domestic product – or in plain English, everything that is made and consumed in the country. The two companies produced a certain amount of goods. When they become one company, they still produce roughly the same amount of goods. There may be some efficiencies gained that boost production on the margin, but that also comes with the fact that two companies becoming one usually involves some people losing their jobs. This activity is great for owners and for Wall Street, but it doesn’t really help the economy.

Today we seem to be in the mirror image of what occurred in The Great Recession following the 2008 financial crisis. For nearly 8 years after that crisis, we kept hearing from Wall Street and economists that growth was right around the corner. Yet years after the crisis ended surveys suggested that most people still thought we were in a recession. Why? At that time the Fed aggressively reduced interest rates, eventually all the way to zero. Money was practically free to borrow.

This spurred a boom in housing and in mergers and acquisitions – big purchases that require borrowing. Housing will stimulate the economy, but as we discussed, mergers and acquisitions don’t really add to the economy as a whole. So, while business owners and financial professionals benefited from free borrowing, the bulk of the economy just didn’t grow. This led to an environment where economic growth kept disappointing the financial experts.

Today interest rates are rising, and the same financial experts who kept predicting growth that didn’t come a decade ago are predicting a recession that has yet to show up now. We can see why Fed policy impacts the owner class and financial professionals much more than it impacts the economy as a whole, but why can’t the economists see it? My theory is that it is human nature to see the world through one’s own view. In my experience, this happens regardless of one’s level of sophistication. We all tend to believe that people think the way we do, and that what we are experiencing is what everyone else is experiencing.

When interest rates are very low, things like mergers and acquisitions happen easily, benefitting business owners and financial firms who are the primary employers of economists outside universities. Their economic lives are good, so their view of the economy is positive. When interest rates are higher, things like mergers and acquisitions become harder, and that hurts business owners and financial firms. Their economic lives are in recession, so their view of the economy is negative.

Meanwhile, the vast majority of consumers are just going on with their lives. When there are a lot of mergers and acquisitions happening, rank-and-file employees are under stress. Things at work are changing and some are likely to lose their jobs. They may even curtail their spending. When interest rates are high, there is less change at work. The consumer hangs in there.

This explains a great deal about why, in the last 20 years or so of record-low interest rates, the gains in our economy have skewed to the owner class and financial professionals. There has been disappointing overall growth and an increase in inequality. It also explains our current situation, and the different stories from our client in the field and the chief financial officer.

But what about the slowdown driven by government sanctions on Russia? Economists love to analyze interest rates and tax rates because these are numbers and can be quantified. Government regulation, on the other hand, cannot be quantified easily, if at all. Sanctions against Russia are a great example: As long as our government says no to Russian grain, it will not come here. It doesn’t matter how much demand there is for grain, or what interest rates are. This is a structural barrier that cannot be overcome. Only the government can remove that barrier if they so choose.

I do want to be clear: Sanctioning Russia may very well be the right thing to do, but that is a political judgment and not an economic judgment. These sanctions, like all government regulations, create structural barriers to economic activity that cannot be overcome by attempting to stimulate the economy. This is important to understand, because over the last 23 years, there has been only one period of time when economic benefits were flowing to rank-and-file workers faster than to owners: that was in 2017-2020, when we saw the first decline in regulation since the 1990s.

When structural barriers are removed, then we can get real economic growth, which benefits everyone, instead of financial engineering, which only benefits the few. Today we are going in the opposite direction, which does not bode well for the longer term.

In the meantime, the economy is hanging in there better than most experts suggest. This is because rising interest rates are not actually stopping consumers from living their daily lives; they are, however, making it harder for mergers and acquisitions. They triggered a bear market last year.

This all means that those experts who are predicting doom and gloom are themselves experiencing a personal economic recession, coloring the lens through which they make their projections. What they are really saying is that they are being hurt by this environment and therefore they assume everyone else will be hurt as well. It is understandable, but it may not work out that way. We maintain our view that we will either escape a recession all together or have a very mild one. We are not basing that on our business, but on feedback we get from others.

So, how is your business?

Warm regards,

Chuck Osborne, CFA
Managing Director

~How’s Business?

We have wrapped up one of the strangest years in the financial markets in my memory. It feels like we are living in Bizarro World. For those who did not grow up with “Superman” comics, Bizarro World was a planet where everything was bizarre.

We had high inflation, which we (and every other analyst I know) saw coming, yet somehow the Fed did not. We had two quarters in a row of real GDP declines, which has always been the practical definition of a recession, but pundits insist that it wasn’t a recession this time. We experienced the worst stock market since 2008, and to add some salt to that wound, the bond market collapsed. The U.S. Aggregate Bond Index goes back to 1977, and in those 45 years, bond prices have been down only five times. The worst decline before 2022 was in 1994 with a 2.9 percent drop; In 2022, bonds dropped 13.01 percent.

The bond market carnage at least makes sense, as the big issue in 2022 was inflation. Inflation causes interest rates to rise, which the Fed’s actions accelerated. The stock market, however, is a more nuanced story. It would be easy to relate the drop directly to inflation, and inflation can certainly hurt some companies; however, inflation actually helps more companies than it hurts, at least on paper, as stated earnings get inflated with everything else. Energy companies are a great example of this and were the best place to be last year.

Stocks dropped because the majority opinion of market participants is that the Fed raising rates will cause a recession. In the 30-plus years I have been in this business, I do not recall a time when so many were so convinced that a recession was inevitable… which is precisely why I doubt a severe recession will occur this year. Perhaps I am being a bit of a wimp in adding the caveat of “severe” here, but stay with me.

Before I explain our thought process, it would be good to discuss what causes recessions in the first place. The economy flows in a way not dissimilar to nature: There are seasons, and spring leads to summer, which gives way to fall, and eventually winter. Winter, with all of its brutality, gives birth to a new spring. Trees grow, they mature, then fade and die, and in doing so, fertilize the soil for a new tree.

Similarly, a business also has a spring, summer, fall and winter. The four largest companies in America today are Apple, Microsoft, Alphabet, and Amazon. Apple was founded in 1976 and Microsoft in 1975. Alphabet was founded in 2015 as the parent of Google, which was founded in 1998. Amazon was founded in 1994. The four largest companies in the U.S. today did not exist when I was born, and two of those four did not exist when I graduated from college. How about you?

Nature has its seasons, and the economy has the business cycle. The cycle starts with new growth, new ideas, and new products. It grows into a flourishing summer, and when all looks positive, it then matures into fall and finally dies in winter.

That death brings forth new life, and the cycle repeats. This is the life of a company, and when we combine all the companies that currently exist, we get an economy. The difference between nature and the business cycle is human psychology.

The great sin of humankind is the thought that we can control things which cannot be controlled. In the Abrahamic traditions, Adam and Eve brought sin into the world when they ate the fruit of the tree of knowledge in order to be like God. In the Eastern traditions, they speak of having to give up the illusion of control. The ancient philosophers warned of hubris. This is a universal truth, and a bedrock of every tradition that has stood the test of time.

This manifests itself in the business cycle as companies experience the summer of their existence. We start our company selling widgets; our widgets are better than any widget that has previously existed, but in our spring we must overcome the newness. We must get our message out, then scale our production to meet the growing demand. If we survive this season, eventually we enter summer. Growth comes easily. We are no longer a startup but the leader of our industry. Demand is sky-high, manufacturing has been optimized, and profits flow.

If we were animals, our instinct would be to know that fall is coming with winter after that. We would prepare for our survival. But we are not animals, we are human beings, and we constantly believe that summer will last forever. At the moment when we should be storing up the fat for winter, we decide to expand instead. We overreach, and this brings on the fall.

Fall is not that bad. The colors are beautiful. It may start to get a little chilly, but it is nothing a sweater won’t fix. For our business we become a cash cow. Growth in demand has fallen, but we have become very efficient at making our widgets and they are more profitable than ever. We may be selling fewer of them, but the increased profit keeps our illusion of summer alive. While even the squirrels are wise enough to store all the falling nuts, we convince ourselves that we are still in control.

Then winter hits. In nature the animals hibernate and live off their fat stores, but our business was running very thin. We must take drastic measures. Payrolls slashed and factories shut down. We have brought on a recession. When recessions hit the unprepared, cuts have to be made. Like trees falling in the forest, those cuts lead to new growth.

We had severe recessions in the 1970s, when technology giants like IBM and Hewlitt Packard had to lay off employees – employees who would then take a chance to work for inspired startups named Microsoft and Apple. Twenty years later, a savings and loan crisis caused a recession and companies started trimming the bloat that had built up in the booming 1980s. Those trimmed workers staffed internet startups such as Google and Amazon.

Winter brings forth spring, but with all due respect, there is no cliché about people retiring to Minnesota. People retire to places like Florida because as a whole we prefer summer to winter. Of course, the four seasons take place in one year, while the business cycle historically took place over a five-year period. Macroeconomists have searched for a way to stop winter from coming. John Maynard Keynes theorized that we could stop it by having the government spend more when things began to slow.

Keynes’s theories dominated the period that led to the high inflation, high unemployment, and low growth of the 1970s. It was a disaster. Milton Friedman thought it better to use monetary policy – the Fed could keep us from recession by manipulating interest rates. As a result, we have successfully lengthened the business cycle from five years to a decade or more. The good news is that winter takes longer to come; the bad news is that the winters have become severe – the tech bubble, real estate bubble, and financial crisis. The more people become convinced that “this time it is different” and winter won’t come after all, the worse the impact of the inevitable change of season will be.

Why is that? Winter is fairly mild here in Atlanta, but those who have experienced a Southern winter often speak of it feeling colder. I blame the humidity. Years ago, I mentioned this to my boss at the time. He was from Detroit and knew a thing or two about winters. He just looked at me and said, “That is because you people don’t wear coats.” He was right, and I have forsaken my Southern roots ever since and brought out the coats anytime it gets cool outside.

This brings me back to my somewhat gutless prediction: I believe we may escape a recession in 2023, or if we do not escape entirely, that the recession will be very mild. I say this because everyone seems so convinced that winter is coming that they are actually preparing for it. Recessions happen, especially severe ones, because we constantly believe they won’t come and therefore overextend ourselves.

We are not overextended; this may be the silver lining in the very dark cloud which was our reaction to the COVID- 19 pandemic. We had not had a recession since the financial crisis of 2008, so we were overdue, but as we entered 2020, all was well economically speaking. We were experiencing the best economy we had seen since the 1980s and 1990s, then we decided to shut the world down in an effort to control the path of a virus. (There is that control thing again.) So, recession started.

We were rebounding from that self-inflicted recession when we decided to reverse course on the lessons of the 1970s and once again embrace the inflation-causing Keynesian fiscal policies of the past, which has landed us where we are today. We are less than three years removed from the last recession, and we are nowhere near the end of a new business cycle; if anything, we are closer to the beginning. This is not the environment which leads to severe recessions.

That doesn’t mean we might not have a slowdown or even mild recession. This can simply be a self-fulfilling prophecy: If everyone slows down to stock up for winter, then economic activity will decrease. Additionally, when we speak of recession, we are referring to the economy as a whole. There are always exceptions. Energy companies have been going gangbusters, but they did horribly for the decade before when technology companies thrived.

Today the economy as a whole may be hanging in there, but the mortgage business is hurting severely and certainly experiencing a recession-like environment. Any industry that is tied to interest rates or financial markets has been hurt. This is balanced, however, with others doing well. One tree falling does not mean the forest is dying.

Critics of capitalism never seem to grasp this. There is a growing movement among some today who suggest that our society is too focused on growth; this is incredibly misguided. There are only two states of being: growth and decay. If we stop growing, then we are decaying. The capitalism critics fundamentally misunderstand what growth of the economy means; they seemingly think of the economy as a tree and even use analogies of trees not being able to grow to the sky. The economy is not a tree, but a forest. The forest can grow forever without ever getting bigger or using up more resources, because the forest hosts new growth along with decay.

The four largest companies today did not exist when I was born. Two of them didn’t exist when I graduated from college. The four largest when I was born were General Motors, Exxon, Ford, and General Electric. They all still exist today, although General Motors wouldn’t if the government had not bailed them out during the financial crisis. All are mere shadows of what they once were, all in the fall of their existence. Who knows what the largest companies will be years from now. Change is inevitable. Recessions are as natural as winter itself; perhaps we would be better off if we stopped trying to control them out of existence.

Warm regards,

Chuck Osborne, CFA
Managing Director

~Inevitable

Myths die hard. For as long as I can remember, there has been a myth that investors must reduce their exposure to stocks and increase their exposure to bonds as they approach retirement. This advice is based on the fallacy that if one is exposed to the stock market and we have a bear market (as we do today) at or close to one’s retirement, then his retirement will be forever impacted. He will have to live on less and suffer for his bad timing.

That is wrong. It is wrong in lots of ways, but most importantly it ignores a far greater risk: outliving one’s resources. In the 30 years I have been in the investment business, primarily focused on retirement, I have seen four huge mistakes that need to be avoided at all costs. The first is taking too much risk when one is young, then panicking and selling everything during a bear market. We talk about this often.

The second is retiring without a plan. I am not talking about a financial plan; I mean an action plan. What are you going to do that will take up your time and fill your life with meaning? If you do not know the answer to that question, then you are not ready to retire. Vacations are great, but they are largely great because they are short. If one retires at age 65 today, then she is likely to be in retirement for 25 or 30 years. One can only play so much pickleball. She had better have a plan as to what will keep her active and engaged with others.

The third mistake is outliving one’s health. Modern medicine is designed to keep one from dying, and they have gotten really good at it. That, however, is not the same as living. The more I deal with retirees, the less I care how long I live. I just want to really live right up until the end. Even if you have never exercised in your life up to retirement, you had better start, because your ability to physically function is a use-it-or-lose-it skill.

The fourth mistake is the one we will deal with in this article: becoming too conservative at or in the decade or so before retirement. This leads to outliving one’s resources, and if there is anything as horrible as outliving one’s health, this is it. The risk of outliving one’s resources is the risk that investors should think about the most. It dwarfs the risk of market volatility, yet that is what most people think of as risk. Most people look at what has happened to the market this year and think, “This is risk; this is the scary part.”

It is human nature. We know better, but it is difficult to see the current value of one’s investments drop and not be anxious about it. That is a normal reaction, but we have to remind ourselves that this is part of the cycle of life. We see ups and downs, and the ups will outweigh the downs over time as long as we stay the course. Time is on our side. Since 1926, the S&P 500 has been up 72 percent of the time. We get a negative year on average once every four years. This will pass, and the market will go to new highs.

This truth leads to one of the fallacies that causes people to hit the brakes too soon. They say, “If you are young then you have time to recover, but if you are about to retire, then you do not.” Wrong! This is the fallacy of the wrong time horizon. An investor who is investing for her retirement does not have a time horizon that ends on her retirement date; her time horizon is her life expectancy, which today is at least 20 years after retirement. I use 20 because when I was an economics student, we learned that as far as mathematical projections go, 20 years equals infinity. Anything beyond that time period is pure garbage. In our investment policies, the longest time horizon one can have is 20+ years, and one has that time horizon into their 70s.

How did the idea of retirement as an end date ever get started? Unfortunately, that has to do with the evolution of the investment industry and the incredible difficulty the industry has in serving investors through retirement. Many years ago, investors either did it themselves or hired an investment adviser to manage their money for them. Either way, all the actual transactions had to go through a broker. In fact, to simply know what was happening in the market that day one had to go to a “wire house” brokerage firm. These were the large New York-based broker-dealers who would pay the expense of having a wire service run to their regional offices around the country.

These firms had brokers in all of these offices because the only way to transact was in person. Technology has replaced that entire system. If your phone has a cell signal, then you can know what is happening and can trade stocks. In most businesses this would have meant the end of the broker, and in my opinion it should have. However, in the investment business, the broker transformed himself into the financial adviser. The broker’s historical role was that of a salesperson. If his broker-dealer had stock of GE, then he would be selling GE that day. The next day they might have a bond from GM, and he would sell that.

The role has not really changed, but most people today are not interested in paying the high cost of buying a stock or bond from the salesperson when they can do it far more efficiently online. Today the financial adviser sells money management; unfortunately, he isn’t a money manager. However, this works for most money managers, because they frankly are more comfortable looking at spreadsheets than talking to people. They can manage money the way they want and turn it into a product that gets sold by financial advisers, who are generally good with people.

Hence, the money management industry evolved from a service profession to a product manufacturing business. The brokerage business evolved from selling stock and bonds to selling managed products. This is far from ideal in our opinion, but it does work for accumulating resources. The vast majority of the products sold by advisers are geared toward growing one’s investments, so while a truly tailored approach is not possible, it is possible to build a portfolio of products that will grow in value over time.

The problem comes when one retires and transitions to producing income. While everyone who is still in the accumulation phase can be oversimplified as needing to make money, each person in the income phase has a truly unique situation. Designing a product for that is like trying to fit a square peg into a round hole – it simply will not work.

It also leads to the idea that when one retires, she must take all her money and put it into an income-producing product. If one did that, then the balance of the portfolio on the day of retirement becomes extremely important. If the investment industry is just a product-pushing business, then the timing of switching products becomes much more important than it should be.

At Iron Capital, we do not believe that the industry should be about pushing products. We believe it is supposed to be a professional service. As such, we build each income-producing portfolio from the bottom-up, tailored to each client’s needs. Our philosophy is simple: Build a portfolio that generates the income needed while taking as little risk as the market will allow.

We have been in a historically low-interest-rate environment for most of the last 20 years, certainly since the financial crisis in 2008. This hurts most income-focused products because they primarily invest in bonds. Bonds, after all, are simply loans. The loans are paid back plus interest, which produces income. The industry has really struggled in trying to solve the retirement income puzzle in this environment. For the most part, they just gave up and started telling their clients that they would have to live on less.

Article after article preached the demise of the so-called 4 percent rule – the “rule” that one could only take 4 percent of their portfolio as income if they wished to preserve the capital. In the meantime, most of our clients need closer to 6 percent. The product-based solutions are no solution at all. We have delivered the income our clients need by taking the best income sources available at the time. For most of the last 20 years that has meant dividend-paying stocks, preferred stocks, and higher-yielding bonds.

The good news is that while we have more in stock, the stocks we were investing in for these clients are more conservative. They tend to hold up extremely well during market downturns. The one exception to that rule was the Covid shutdown. These conservative companies that pay dividends tend to do well in thick or thin, but not when the government says you have to shut down. So, what did we do?

We put enough in safe places to pay the income needs for a few years, and then took advantage of the silver lining of the downturn. Every bear market creates opportunity. We took advantage of that opportunity to rebuild our client’s income portfolios. This is also what one should do when retiring in, or shortly after, a bear market.

When producing the needed income is a professional service and not a product, one gains flexibility. There is no need to have a one-time flip of the switch; the transition into retirement is exactly that – a transition. There is no rush, as we are going to be managing the income production for 20 to 30 years, if not longer. There is no need for a bear market at one’s retirement to be any different than a bear market at any other time.

Today we are in a bear market, and it is creating opportunities. For the income-needing client, those opportunities are now in bonds. For the first time in a very long time, bonds are paying enough interest to be a meaningful portion of an income strategy. This, however, is not going to help the product pushers. Bonds are simple: One loans his money to a company or government, and the borrower promises to pay it back plus interest. If one buys a bond, then she will get interest payments, and at maturity, the return of her principal. There is a risk that a borrower will not be able to pay it back, but that risk can be judged up front.

Bond funds, i.e. the products, do not work that way. What one is really doing is buying shares in a mutual fund. The fund then invests in bonds. Should interest rates rise further, the bonds will lose value in the market. A bondholder who isn’t selling doesn’t care, because she will continue to get what she agreed to from the beginning. The bond fund, however, will lose value. It does not behave like an actual bond; it behaves like a mutual fund that happens to invest in securities with lower return potential.

Retirement is a personal experience. It is a stage of life, not something one buys from a store. Managing one’s investment portfolio to produce the needed income is just as personal and just as unique. If one wishes to go the product route, then he had better have saved a lot of money and avoided the last-minute downfall. On the other hand, if one goes the route of professional service, then she will be able to navigate life’s ups and downs with far more flexibility. Bear markets are horrible to endure, but they do produce opportunities – even for those about to retire.

Warm regards,

Chuck Osborne, CFA
Managing Director

~Retiring in A Bear Market

As our economy slows and inflation remains stubbornly high, one must wonder if we will ever learn our lessons. We have been here before and we know what causes this, yet here we are once more. We did not learn the lesson of the 1970s; but why?

I believe it is the all-too-human instinct to look for one explanation for complex problems, when in truth it is never just one thing. In the case of inflation, most want to look towards the Federal Reserve Bank (Fed). They want to give the Fed all the blame for inflation and all the credit for stopping inflation. While there is some truth in that, it is at best a grossly oversimplified view and at worst just plain wrong.

This is not to say that the Fed can’t do any damage. They certainly share fault for the housing bubble of the 2000s, which led ultimately to the financial crisis of 2008. That too was a complex development with multiple contributors, but in that case the Fed escaped culpability as “bankers’ greed” made for better headlines. However, in the case of inflation I believe the misdiagnosis comes from the two schools of economics.

I have no idea how they teach economics today, but 30 years ago when I was a student one had to learn about “microeconomics” and “macroeconomics.” Microeconomics dealt with consumer behavior, the backbone of which was the law of supply and demand. A product which is in high demand but of limited supply will sell at a high price.

There are other laws of microeconomics such as the law of marginal utility, which explains that the fourth piece of cheesecake is not as enjoyable as the first piece. In fact, it may very well leave one so sick that he never wants cheesecake again.

Macroeconomics is the study of the economy at large. When I was a student, it mostly revolved around the theories of John Maynard Keynes, and the primary focus is what they call “aggregate demand.” This is the sum of all demand for all products in the economy. One would study the different factors that led to aggregate demand and how a government could manipulate those factors to keep the economy growing. Primarily at that time we would learn these complicated mathematic formulas that would predict the growth of the economy based on things like government spending.

In micro class we would study the various laws of economics and see real world examples of how these laws could be seen in action. These were laws, after all, and they worked then and still work today. If one is trained, then one can see them in action. One of my favorite examples would be foreign to young people today who have never seen an actual newspaper, but when I was a student, it fascinated me. Did you ever wonder why the soft drink vending machine would only dispense one soft drink at a time, while the newspaper vending machine allowed one to grab every paper inside if she so chose? This was the law of marginal utility in action. A second soft drink may have less value than the first to a thirsty consumer, but it still has significant value. A second newspaper is worthless unless you are using it for something other than reading. So vending machines allowed only one soft drink, but every remaining newspaper – knowing consumers would take only one newspaper, but would likely take more than one soft drink if given the chance. Occasionally some Robin Hood-type character would grab the whole stack of papers and place it on top of the machine for others to get a free paper, but that didn’t happen enough to hurt the newspaper business.

In macro class we would learn mathematical formulas for predicting GDP. We learned the basic Keynesian formula. We practiced it and practiced it, and then we would be tested. After the test the professor would come in and say, “Well that is the basic formula, but it didn’t actually work in real life.” Then we would learn a more complicated formula. We practiced it and practiced it, and then would be tested. After the test the professor would come in and say, “Well that is the second iteration of the formula, but it didn’t work any better.” We would learn an even more complicated formula…well, you get the picture.

It should be obvious based on my description that I gravitated to microeconomics. It should also not be a surprise that here at Iron Capital we believe in bottom-up investing; in other words, the micro view of investing. Our top-down, macro view is simply the sum of all the bottom-up micro views. What does this have to do with inflation? Everything.

The view that the Fed caused inflation and, more importantly, that the Fed can cure inflation, is a macroeconomic view. It makes for some wonderfully complex math that a professor can really enjoy teaching to young economic students, but after the test has been graded, she then has to explain to the class why it doesn’t work in the real world.

Low interest rates theoretically would encourage more borrowing, which stimulates aggregate demand. How truly effective this is in stimulating the economy cannot be known. One problem with macroeconomics is that, unlike science, there is no control group. There is no way to know exactly what impact the Fed has on the economy. We know that during the recession brought on by the financial crisis, the Fed went to extraordinary measures to boost aggregate demand and thereby the economy. We know that the recession ended, although the recovery was anemic and most thought we were still in a recession. It seems logical that the Fed’s actions were helpful in stimulating demand, but we can’t know for certain. Congress was also taking action in the form of TARP, and of course recessions will simply end on their own, so how can we know?

Fast forward to the pandemic and the Fed acted once again, but having never fully undone the actions of a decade earlier they had fewer options. They encouraged Congress, who also acted, and acted again, and again. Both fiscal (spending through Congress) and monetary (Fed action) stimuli supposedly boost aggregate demand. In theory, the boost in demand will raise prices, suppliers will act to raise supply, and the economy will grow with low controlled inflation.

This does not seem to be working, and it didn’t work in 1970 either. When supply doesn’t react but demand gets stimulated, we don’t get growth, we get inflation. Back then, as now and always, there wasn’t just one cause. We had runaway government spending from the Johnson administration that kept going under Nixon. We had an OPEC oil embargo. We had civil unrest surrounding Vietnam and we had a crisis in Watergate. In 1970 the Fed raised rates from 4 percent to 9 percent and we dove into a recession. Inflation persisted. Four years later the Fed raised again, this time from 3.5 percent to 13 percent, and once again we went into a recession. Once again, inflation persisted.

While the Fed tried to kill inflation by lowering aggregate demand, other government programs were stimulating demand. Nixon implemented price-fixing, which caused shortages but was a boost to demand. Simultaneously there were restrictions on the production of supply. Our economy was over-regulated and the maximum income tax rate was 50 percent. This has an impact. In the late ’70s my father took me to buy my first suit. He had known the salesman for several years and half-jokingly asked him why he wasn’t the manager by now. The gentleman responded that he had been offered the job, but the raise would put him in a higher tax bracket and his take-home pay would actually go down. That was a disincentive to work harder and provide more supply. The Fed couldn’t fix that.

It was not until Jimmy Carter began deregulating U.S. industry, then Ronald Reagan continued that trend and also reformed the tax code, that inflation was beaten. It should be no surprise that the official term for “Reaganomics” was supply-side economics. By stimulating supply, inflation was tamed. It still took the Fed raising rates once again, and we will never know if that was necessary, but it happened and inflation was beaten.

We failed to learn that lesson and today we are repeating history. Inflation peaked in 1980 at 14.76 percent. The government has since changed how inflation is calculated. Larry Summers, National Economic Council Director for the Obama administration, has recalculated historic inflation rates using today’s methodology. Based on his work that peak would be reported as 9 percent today, not far from the 8.6 percent we are experiencing.

We have an energy crisis today caused in part by overly optimistic “green” policies and the Russian invasion of Ukraine. We are coming off a historical reaction to a pandemic that shut down much of the productive capacity of the free world. We have members of Congress asking for price controls and a re-emergence of regulation through executive action. In other words, we are making very similar mistakes and getting a very similar experience.

The Fed can act aggressively and have an impact on aggregate demand, but that won’t help supply. The Fed gets far too much credit and blame. It didn’t get us into this mess by itself. Don’t get me wrong: they made mistakes that have certainly contributed to this mess. They should have backed off on the emergency measures long before they did. However, they had a lot of help, starting with the shutdowns and then all the extraordinary measures taken right up the last trillion-dollar spending package, which went into effect in an economy already growing at more than 6 percent.

Macroeconomic tools – fiscal and monetary government policy – impact only aggregate demand. Supply-side economics was based on a faith in microeconomics; it understood that people react to incentives, and to disincentives. If a salesman in a men’s store would end up taking less money home if he was promoted and got a raise, then he was not likely to accept that promotion and raise. That puts a cap on his productivity and therefore reduces aggregate supply. Governments can stimulate demand all they want, but if supply is simultaneously being held down, then all they get is inflation.

On the other hand, if supply is freed up, then the Fed can have an easy money policy for almost thirty years with little impact on inflation. I didn’t understand that as a young economics student. All I knew was that macroeconomic professors were always making excuses for being wrong and the microeconomic professors were always describing things as they actually were in reality. Macro class had theories and formulas while micro class had laws.

The law of supply and demand determines prices. When supply and demand are in balance, prices are stable. When demand is stimulated while supply is simultaneously deterred, we get inflation. That is how we got here. Understanding that shows us clearly the only way to get out: we must stimulate supply, in a similar fashion to how supply was stimulated in the 1980s. The Fed may need to play a role, but they couldn’t do it alone in the ’70s and they won’t be able to do it alone today.

We learned this lesson once already. While it is frustrating that we have to learn it again, at least this time we know what to do. Here’s hoping policymakers have the wisdom to do it.

Warm regards,

Chuck Osborne, CFA
Managing Director

~How Did We Get Here?