The China Card (Part 3)

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So what has gone wrong in China?

The slowdown in Chinese economic growth has led to a 4% market decline this year, even as other world equity markets are growing at a double-digit rate. It may even have contributed to the recent record drop in Japanese stock prices. But what’s causing their economy to sputter?

Some point to government capital controls: in prior years the banks have had capital requirements raised because of concerns about inflation. But a more likely candidate is capital misallocation. There’s a lot of central management of the Chinese economy—note, for example, their heavy subsidies of flat solar panels. This has led to rampant oversupply and the bankruptcy of several large solar-cell manufacturers—resulting in job losses.

Capital allocation is difficult in the best of circumstances, when price signals can rapidly adjust to new circumstances affecting supply and demand. In an administrative state where prices can be manipulated for political purposes, misallocation is inevitable, and you get overbuilding and underdevelopment, with an accompanying slowdown as the economy adjusts.

Booms and busts happen even in the most developed economies—don’t we know it! China may grow through its problems, but there will be some tough sledding ahead.

Douglas R. Tengdin, CFA

Chief Investment Officer

The China Card (Part 2)

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Why has China grown so rapidly?

There are lots of low-wage countries. In the ‘90s the “Asian Tigers” of Singapore, South Korea, Taiwan, and Hong Kong specialized in finance or high-tech manufacturing and developed rapidly. Now they are fixtures in the global economy, hosting some world-class businesses.

China has become a manufacturing powerhouse not simply via low labor costs, but from its solid logistical performance. Companies only put facilities in places where they can be productive, and to be productive they need adequate infrastructure, efficient services, consistent border procedures, and reliable delivery performance. China has created manufacturing clusters in its coastal regions with eye towards these factors.

Other low-wage countries would have to put decades of effort and pour billions of dollars into their trade infrastructure to put even a minor dent into China’s trade advantage. So as world trade has grown, China has been able to leverage this.

China’s extraordinary growth has been a natural result of its focus on logistics. Its market pullback has come not from external competition, but from internal factors.

Douglas R. Tengdin, CFA

Chief Investment Officer

The China Card (Part 1)

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Has China lost its mojo?

During the late ‘90s and early ‘00s the country became a manufacturing powerhouse, using inexpensive labor and managerial skill to surpass Japan, Germany, and the US in global exports. The value of its stock market soared, growing 5-fold between 1999 and 2007. China’s economy, and especially its coastal areas, have become boom-towns.

But since the Financial Crisis that market has been in decline. Stocks have fallen 60%, led by Chinese oil companies and banks. While other indices have gone on to reach new highs, The best the Chinese composite did was come to regain about a third of what it lost—back in 2009. Since then, the market has been in a steady down-trend.

Has China caught a Japanese flu? Back in the ‘80s Japan’s market was soaring, only to collapse under its own financial bubble. All their borrowing and spending couldn’t jump-start that economy, and their market has been on a 20-year slide.

But China is not Japan. Their economy is still expanding at a dramatic rate because they are a developing economy still building tangible and intangible infrastructure. There’s no evidence that their share of global trade is falling, and their entrepreneurial culture is intact.

China’s economy is still highly competitive. It’s market pullback will reverse, once they deal with some of the problems their growth has created.

Douglas R. Tengdin, CFA

Chief Investment Officer

Moving Mountains (Conclusion)

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So how do you stay safe in the mountains?

One way to stay safe is not to go–to conclude that the risk is too great, that the weather is too poor and the opportunities too scanty. So it’s just more rational to stay home and water the garden.

But the mountains offer us vistas and light that we don’t get in the valley. It’s not just “because it is there.” Sometimes going over the mountains is the only way to get where we need to go. And sometimes we have to invest in risky markets in order to achieve our financial goals.

So the final lesson in risk management that the mountains teach us is knowing the right time. If you’re venturing out among the peaks, it’s essential to understand the regional and local weather—to know what’s coming and how it’s likely to be affected by the elevation and changing temperatures. In the same way, investors need to understand how global and national economic and financial conditions will affect their markets and investments. And sometimes the conditions are too sketchy—and we don’t head out when that’s the case.

Last week I started up Mount Washington for some spring skiing, but the conditions deteriorated and I turned back. Because the mountains will always be there. Waiting for the right conditions means we’ll be able to come back another day.

Douglas R. Tengdin, CFA

Chief Investment Officer

Moving Mountains (Part 4)

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In spite of all you do, stuff happens.

In spite of all your preparation, all your planning, all your experience, mountains and markets can and will surprise you. Mountains are chaotic systems: they disrupt the airflow around them, and so they can create extreme situations, where the turbulent winds and a lack of cover transform a beautiful clear day into a massive maelstrom where there’s no shelter.

Markets are chaotic as well. That’s why the patterns we see, while perhaps reminiscent of previous market cycles, are always new. The most dangerous phrase in investing may be, “It’s different this time.” But in a very real sense, it’s always different. What makes that phrase so perilous is that it is often used to justify improper actions, that in “normal” times we would condemn as foolish.

So how do we adapt to market and mountain chaos? First, don’t panic. The surge of emotion that comes when things go wrong is rarely helpful. Second, follow the plan unless it’s obviously wrong. When the compass says to go one direction and your instincts say go the other way, follow the compass. Likewise, if the plan is to trim when a sector becomes 10% overweight, do it. It’s never easy to cut back on a winner. That’s why it’s a winner. Finally, don’t be afraid to turn back. Just because you’ve put money into a position doesn’t mean you should put more money there. Sunk costs are just that: sunk. We have to decide what to do based on current conditions, not based on what was done in the past.

Knowing that the best laid plans will have to be adapted as conditions change is important. It means you’ll be ready when things go wrong.

Douglas R. Tengdin, CFA

Chief Investment Officer

Moving Mountains (Part 3)

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It’s been said that the difference between danger and disaster is preparation.

“Be prepared” is the motto of the Boy Scouts, and it’s good advice when you’re headed into the mountains. You need to be physically ready for challenge of the peaks—core body strength, cardio-vascular endurance, and mental energy. You need to have adequate clothing and emergency supplies, like a headlamp and compass. And you need to know the mountain and trails you’re going to. Maps, guides, and experienced friends help you understand where you are and what surprises might be around the next bend in the trail.

Investors need to be ready for what the markets might throw at them as well. Research, documentation, and mental preparation are critical to dealing with the surprises that markets inevitably send us. Researching investments can take time, but it’s worth it. If you understand what a business does and how it generates its cash, then the market’s gyrations are less likely to cause you to panic.

Documenting your decisions is also a great defense against second-guessing yourself. Going back to your files to see why you bought or sold what you did when you did will help you learn about both the markets and your own mind. And understanding ourselves is the real key to investment success. Recognizing how much risk you can tolerate and your other limitations is an ongoing process—and the way we prepare mentally for the markets.

With preparation, market volatility becomes opportunity. Without preparation, it can lead to permanent losses to a portfolio.

Douglas R. Tengdin, CFA

Chief Investment Officer

Moving Mountains (Part 2)

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What are your limitations?

It’s tempting to disparage limits, to say that they stop people from doing what they want to do when they want to do it. But setting limits is just a way of acknowledging our humanity—that we live in a real world, not a projection of our own imaginations.

On Mount Washington acknowledging your limitations can save your life—establishing factors like turn-back times, where you decide not to press on to the summit, no matter how close you are; or recognizing that some runs are too just too hairy for your skiing skills right now.

Limits can be physical or they can be psychological, but in either case they’re real, and they keep us from making foolish decisions in the emotion of the moment. It’s the same with investing. If you’ve determined to have a 50/50 split between stocks and bonds with a 10% window, then it’s time to rebalance when it gets to 60/40. Similarly, if you don’t want to have more than 5% of your portfolio in any one stock, then when something becomes dominant—as GE did in the ‘90s, or United Health did 5 years ago, or Apple recently—then it’s time to trim that position. Such limits have saved investors a lot of money and a lot of tears.

Setting limits is a way to determine guidelines rationally when the fog of the mountains—or markets—would entice us to act irrationally. They keep us grounded in what’s real, and they keep us out of trouble.

Douglas R. Tengdin, CFA

Chief Investment Officer

Moving Mountains (Part 1)

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How does respect fit into risk management?

When you’re in the mountains, the first thing you learn is respect for the mountain. No one ever “conquers” a peak. Hillary didn’t “conquer” Everest; Whymper didn’t “conquer” the Matterhorn. The men and women who made first ascents did something unprecedented, but the mountains are still there.

And what we respect is the mountain’s weather, its terrain, its remoteness, its unpredictability. Mountains have a way of surprising you, and because you can be far from help, minor issues can turn into major emergencies.

In the same way markets can be infinitely surprising. What should be an orderly process of buying and selling can break down, and you get a “flash crash” like what happened in May of 2010 or supposedly safe portfolio insurance can cause a market meltdown like October 1987. Markets are always creating a new new thing, and new ideas engender new risks and opportunities.

Respecting markets means working with them, not trying to outsmart them.

Douglas R. Tengdin, CFA

Chief Investment Officer

Moving Mountains (Introduction)

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In the spring, skiers from around the world come to Mount Washington for its celebrated backcountry snow. Tuckerman’s Ravine is legendary—its 50-degree pitches and rugged beauty combine to give mountaineers some of the best spring skiing anywhere. And the only cost is the challenge of carrying your own equipment into the bowl and up its pitches.

I’ve been going up to Tuck’s for over 15 years, but I’ve only skied there about 2/3rds of the time. The reason is risk. Mount Washington is a beautiful place, but it’s also a dangerous place. The same conditions that make it so attractive also make it risky. It’s home to some of the worst weather in the world.

Managing risk is critical to enjoying the mountain. And managing risk is also crucial when you’re investing. Over the next several posts I will examine four aspects of risk management: respect, limits, preparation, and uncertainty. These four factors can help anyone get into the markets—and the mountains—safely.

Douglas R. Tengdin, CFA

Chief Investment Officer

End the Fed (Easing)?

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This is the way the Fed ends its easing. Not with a bang but with a whimper.

With apologies to T.S. Eliot, the Fed doesn’t have to end its innovative asset-purchase program with grand announcements and immense bond sales. It could, of course. It could declare the end of quantitative easing tomorrow, and begin selling tens of billions of Treasuries every day to reduce rapidly its $3 trillion balance sheet. Such an approach would overwhelm the markets. There isn’t enough liquidity available to buy the Fed’s supply. Interest rates would spike and global markets would plunge.

So such an approach would destroy the US and world economy. The only asset that might appreciate in such a scenario would be cash, as interest rates would zoom upwards. For obvious reasons, the Fed is unlike to adopt such an extreme approach—“going from wild-turkey to cold-turkey,” as one Fed President has put it.

Instead, they are much more likely to simply reduce their asset purchases gradually, assessing the impact as the current $85-billion / month program goes to $60 billion and then $40 billion and so on. Most of the Fed’s debt matures in well under ten years.

The first step would be to lay out an exit plan and float it publically, as they did recently in the Wall Street Journal. But it took years to adopt our current monetary-policy mix. It’s likely to take years to get out of it as well.

Douglas R. Tengdin, CFA

Chief Investment Officer