The Elusive Steady-State

Will the economy ever get back to normal?

Source: Wikipedia

Everyone wants the economy to normalize—normal interest rates, normal economic growth, normal inflation. The Fed is talking about that issue this week in Jackson Hole, Wyoming. But we never seem to get there. Something always seems to come up.

Ten years ago, the economy crashed during the financial crisis. Five years ago we had a Euro crisis and fears of “Grexit.” Now “Brexit” and the most bizarre presidential contest in memory are roiling expectations. Economists debate whether we’re in a “new normal” or secular stagnation or if the rising “gig economy” will turn us all into innkeepers, taxi drivers, and dog-walkers.

Some see the market as a complicated machine, with levers and buttons for policy-makers to push and pull. All we need to do is find the right mechanism to increase output. But it’s really a complex ecosystem, with stresses and stimuli from invasive species, new adaptations, over-harvesting, and an infinite number of other internal and external factors. If you walk into a forest, nothing is ever stable. It’s always in a transition from something old to a new new thing.

Photo: Petr Brož. Source: Wikipedia

The economy never has been nor ever will be in equilibrium. The economy we have is the economy we need to work with: first to understand it, then to encourage increased, sustainable growth. Markets are always shifting, challenging the most nuanced and elegant models. But markets don’t do elegance. If you want elegance, see a tailor.

Douglas R. Tengdin, CFA

Chief Investment Officer

The Ups and Downs of Index Investing

What are market indexes?

Source: The Reformed Broker

A market index is just a group of securities. With 7000 investable stocks in the US, there are 2 7000 possible combinations. But actually, with different weighting schemes, there are more. This means there are now more indices out there than there are large-cap stocks. With index-based Exchange Traded Funds (ETFs) widely available, index investing has come to resemble particle physics, with quantum creation and destruction, spooky entanglement, and a fund’s success often predicated on its spin, strangeness and charm.

The first index was created by Charles Dow in 1896 as a simple average of stock prices. Index methodology moved towards using market capitalization—the stock price times the number of shares outstanding—as the principal means of weighting equities in an index. Now, there are over 130,000 global indices calculated and tracked by S&P / Dow Jones—from the Philippines Property Index to Philadelphia Oil Services. Many observers have noted that there appears to be a “bubble” in indices.

Indexes help investors evaluate a manager’s skill relative to a benchmark, and give them the opportunity to put their money into a widely diversified portfolio if they choose. Now, what used to be looked at as the value-added of stock picking can be reduced to quantitative factors, and individual managers’ approach can be simulated and back-tested. Even Warren Buffett’s portfolio—with his preference for “wide moats” and consistent cash flow—has been cloned and replicated. So even after he passes away, his methodology can live on.

Source: Frazinni, Kabilla, and Peterson

But cap-weighted indices aren’t really neutral. They have their own biases. The gradual dissemination of new information into the market—and its incorporation into securities prices—means that these indices carry a certain amount of momentum. Also, since the priciest stocks are weighted the most heavily, they also have a growth tilt to their composition. So index investing is really growth-portfolio momentum investing.

In addition, cap-weighting creates its own paradoxes. When a company buys back its shares—everything else being equal—its price goes up while the number of shares goes down. Individual shareholders will profit as their ownership stake in the company increases, while index investors would not—the market cap doesn’t change. The converse holds true for companies that issue new shares, diluting the ownership of their shareholders. Individual shareholders would be hurt; index-holders would not.

Finally, technical issues related to index investing can lead to significant short-term price volatility. The flash crashes of May 2010 and August 2015 caused a lot of turmoil, and the Crash of 1987 was also linked to index-based portfolio activity. While the fundamentals of the market and economy had not changed, it appeared for a while as if the market was anticipating serious problems.

All this is not to suggest that indexes and index-based investing are bad. On the contrary, cap-weighted indices have been helpful for investors and are now central to modern money management. Like most areas of life, however, it’s important not to go too far. “When you find honey,” Proverbs says, “eat just enough. Too much, and you’ll get sick.”

Douglas R. Tengdin, CFA

Chief Investment Officer

The Tyranny of Norms

Will the economy ever get back to normal?

Source: New York Fed

Fed officials keep telling us what they want. But that’s not their job. The Fed was established to support the banking system—to serve as bankers to the bankers. Part of that job involves managing bank reserves, the money supply, and short-term interest rates. The 1978 Humphrey-Hawkins legislation specifically instructed the Fed to pursue two goals: full employment and price stability. This is sometimes called the Fed’s “dual mandate.”

So it is understandable that policy-makers would look at developments in the economy positively or negatively, based on whether they represent progress towards reaching these goals. If you listen carefully to what they say, however, you can learn a lot about the FOMC members’ plans, intentions, and expectations – beyond these narrow confines.

They talk about positive and negative developments in the economy, in the markets, about what policy should do, and where they want interest rates to go. This is understandable—economic statistics represent financial reality for hundreds of millions of people. When the economy goes south, our plans and hopes and dreams may have to change. No one wants to see others suffer because of policy errors.

But it’s dangerous for officials to discuss where the economy “should” go, about what they “want” policy to do. The wish is father to the thought, as Shakespeare wrote. By saying what they want, Fed chieftains constrain what they might be able to do. And hindsight bias means that they are at risk of finding what they’re looking for in the data—whether it’s really there or not.

The economy we see is the economy we have, whether the leaders gathered at Jackson Hole this week want it to be that way or not. We may all hope that things get back to normal—whatever “normal” means. But this isn’t Oz: we can’t just click our heels together and wish our way home.

Photo: Chris Evans. Source: Wikimedia

Douglas R. Tengdin, CFA

Chief Investment Officer

Reforming Money, Tightening Money

Are money markets doing the Fed’s job?

Photo: Jon Sullivan. Source: Public Domain Images

The Fed is in Jackson Hole this week, discussing how to design a monetary policy framework that enhances the global economy. Luminaries from all over the world will be there—from other global central bank leaders to politicians to academics. On Friday, Janet Yellen will speak, and she is expected to offer some hints as to how she—and by extension, the rest of the Fed—sees the economy, and where Fed policy might go next.

But what if new regulations have already done the Fed’s job?

The spread between 3-month T-Bills and 3-month LIBOR–known as the TED spread–has been a good indicator of financial stress. When banks are reluctant to lend money to one another, the spread widens. During the run-up to the financial crisis, the spread climbed from 0.20% in 2006 to 1.50% in 2007 and topped out at 3.0% in September of 2008, just after Lehman went bust. The higher the TED spread, the more borrowing costs.

But that was then, this is now. For the past several years, the index has been on auto-pilot. There haven’t been many real threats to the banking system. Concerns about loans in the oil-patch didn’t show up in the TED spread. But lately the spread has moved a lot higher. Why?

TED spread. Source: Bloomberg

Mostly, this has to do with reforms to the money market that are part of the Dodd-Frank legislation. In order to prevent a repeat of the financial crisis, when a big money market fund “broke the buck” and caused a modern-day bank run, Congress decided that all credit-sensitive money market funds have to be flexible in how they price themselves. They can no longer guarantee a stable market price. So as much as $1 trillion held in money market funds is moving into government funds. As a result, banks and other creditors have to pay up for short-term money. Since regulation has permanently changed the money-market landscape, these spreads may be permanently higher.

As a result, financial conditions have tightened. Not as tight as they were during financial or Euro crisis, but certainly tighter than they have been. At Jackson Hole the Fed will talk about the right time to take the punch bowl away. But Dodd-Frank’s money market provisions may have already put a lot of water in the punch.

Douglas R. Tengdin, CFA

Chief Investment Officer

Risk, Return, and Investment Fads

Do low-risk stocks have higher returns?

Photo: Chamomile. Source: Morguefile

That’s what a lot of people are thinking. It’s kind of counter-intuitive. After all, it’s always been taught that in order to get returns, you have to take some risk. Bonds are more risky than bank deposits, but they pay more. Long-term bonds are more risky than short-term bonds. Stocks are more risky than bonds—their prices are more volatile, and if a company goes bust, stock investors usually don’t get anything back. For example, when after the financial crisis, investors who owned Lehman’s shares were wiped out, while those who owned senior Lehman’s senior debt received around 30 cents on the dollar. That’s not a lot, but it’s a whole lot better than nothing.

The assumption that risk and return are linked is central to much of modern finance. It is assumed that your total investment returns are generally limited by your risk tolerance. In fact, this has become a central tenet in most asset-mangers’ education. You won’t pass the CFA curriculum if you put a risk-averse 100% into stocks. The theoretical foundation of this practical norm is the Capital Asset Pricing Model, first formulated by Bill Sharpe in 1964. He won the Nobel Prize in Economics for his insight.

But academics began documenting anomalies to the CAPM almost as soon as it was proposed. They discovered a “size effect,” a “quality effect,” and a “value effect.” These factors capture the fact that small companies, well-run companies, and cheap stocks tend to do better than the general market. Lately researchers have been looking at a “low-volatility” effect—the notion that stocks where the price doesn’t jump around as much seem to do better than shares of jumpy firms. This turns risk/return thinking on its head. If the “low-vol” effect is right, then the least risky stocks are better investments—more return for less risk.

Source: Eric Falkenstein, “Finding Alpha

The financial industry has capitalized on this notion, creating a host of low-vol funds and ETFs. These appear to be pretty successful. The five largest funds have almost $40 billion in assets under management, gathering $25 billion in the last two years. Year-to-date, they have returned over 11%, while the S&P 500 is up only 8%.

But on further examination, much of the low-vol effect turns out to come from other factors. High-volatility stocks historically have been penny stocks and the most speculative shares. Penny stock marketing was reformed in the early ‘90s, and when the tech bubble burst, a lot of non-income “concept companies” went away.

Lately, low-volatility stocks have done well, but much of that can be attributed to the recent outperformance of dividend-growth companies like utilities, consumer products firms, and pharmaceutical corporations. Since bonds don’t pay much—if anything—any more, income-oriented investors have shifted their funds from bonds to stocks, pushing the prices of dividend-growth stocks to record levels. The PE ratio of the Dow Jones Select Dividend Index is now 37% above its average level.

Source: Bloomberg

Financial fads come and go. In the late ‘90s it was tech stocks. Before the financial crisis it was China. Now it’s dividend growth. Investors rush into a concept and rush right back out again, leaving disappointment and disillusionment in their wake. Technology and China and dividends remain important investment themes, but not at any price. If you pay too much for anything, your performance will suffer.

In a portfolio, as with clothes, fashion is what you’re offered. But style is what you choose.

Douglas R. Tengdin, CFA

Chief Investment Officer

The Upside of Debt

Is all this borrowing good for us?

Source: St. Louis Fed

A growing level of debt in an economy can be a good thing. By borrowing money to pay for capital, we can become more productive and everyone prospers. Think of the US borrowing massive amounts of money to build the interstate highway system in the ‘50s and ‘60s. The important thing to remember is that the return on investment has to be higher than the cost of the borrowing.

That’s why today’s persistently low interest rates are so puzzling. In normal times, low interest rates would spur investment spending on a host of capital projects. That spending would itself spur economic growth, as the money cycles through the economy. Capital spending makes an economy more efficient, making everyone better off. The borrowing is easily serviced by a growing economy.

But these aren’t normal times. Companies are reluctant to borrow to finance capital investments. They’re worried that there may not be enough final demand, and their projects may get stranded. Apple may be spending over $10 billion per year on research and development, but they’re funding this out of their massive cash flow. Corporate borrowing is being used for financial engineering: CFOs are borrowing money to finance stock buybacks. If they can borrow at 3% to buy their stock with an earnings yield of 5% (a PE of 20x), that’s positive for shareholders. But what are shareholders doing with the buy-back cash? They’re buying more stocks—and share prices are increasing.

Source: Spottradingllc

Rising asset values may encourage some economic activity, but it’s not a very effective transfer mechanism. Ongoing subpar growth requires fundamental change—not just tweaks to monetary policy. Monetary policy can only shift growth around—from country to country, via exchange rates, and from one time period to another, through interest rates. Lower rates pull growth forward; higher rates push it back.

But there has to be growth to push or pull. That’s why fundamental change is needed. Regulatory reform can make it a lot easier to do business. There’s little need, as far as I can see, to make hair braiders get a license in cosmetology. But that’s what many states require. Tax reform can also level the playing field by eliminating special set-asides and lowering the statutory rate.

Debt can be profitable, but only if it’s used as a tool to become more productive. Otherwise, it’s just rearranging the financial deck chairs on an economic steamship headed into the fog.

Douglas R. Tengdin, CFA

Chief Investment Officer

Lucky or Good?

Was it skill or was it luck?

Official Finish Cam. Source: BBC

It was one of the most exciting finishes ever. Two top rowers battled for first place down the 2000 meter course. Damir Martin of Croatia led most of the way. Towards the end, Mahe Drysdale of New Zealand—a former gold medalist—closed the gap. In the final seconds, Martin seemed to hold Drysdale off as they crossed the finish. But it was too close to call. The officials had to examine the finish camera to tell which boat was in front in the final instant.

It came down to the narrowest of margins. Only a fraction of an inch separated the two—less than a hundredth of a second. Martin was the first to applaud as Drysdale was announced the winner. How did Drysdale come out on top?

At the finish, Drysdale happened to be at the end of his stroke—the fastest point for the boat—just when they crossed the line. Martin was in mid-stroke, still applying power. At that point, Dysdale’s boat has a brief moment of maximum acceleration. That was enough to give him the miniscule edge over his rival. Over the 230-or-so strokes that both took to get down the course, the winner’s timing was aligned to be absolutely perfect.

Source: Bleacher Report, NBCOlympics.com

Drysdale was lucky. There’s no way he could have timed his strokes to give him that final edge. But both rowers were incredibly skilled. It was a delight to watch the fluidity and grace that they demonstrated—a perfect blend of technical skill, superb conditioning, and intense concentration. Drysdale wouldn’t have been in a position to be lucky if he hadn’t been good in the first place.

A similar thing is true when we invest. We may own a company that gets taken over, or one that has a blowout quarterly earnings report, and feel lucky that we’ve received a windfall. But you have to put yourself into a position to be lucky—whether it’s through exhaustive research or broad diversification or disciplined investment processes. As Samuel Goldwyn, the famous movie producer, once said: “The harder I work, the luckier I get.”

Douglas R. Tengdin, CFA

Chief Investment Officer

Long Term Investing

Are you a long term investor?

“The Persistency of Memory” by Salvadore Dali. Source: Museum of Modern Art

Everyone claims to be. When the market is high, they claim that they’re not worried about a few small fluctuations. But if stocks fall 5%, you’d think we just declared war on the Republic of Freedonia. Everyone wants to get out—but only for as long as the market is down. Then they’re long-term investors again.

The problem comes because we don’t think about what we have. We think about what we’ve gained or lost. For example, when folks get a quarterly investment statement, they don’t look at their total wealth. They look at how it has gone up or down. And we worry more about the downside than we’re excited about the upside. Psychologically, it hurts more to lose something than it feels good to win. That’s why the status quo tends to be more popular: change always implies that something could go wrong—something that’s working right now.

Risk aversion. Source: Wikipedia

This gives truly long-term investors an edge. If you can look beyond the weekly or monthly squiggles and jiggles, you can invest with broader financial and economic trends in mind. For example, right now the “earnings yield” of the broad market is about 5½ %. That’s the earnings of an average company divided by its market capitalization. And firms can borrow money at about 3½ %. It makes sense in this environment for corporate treasurers to issue bonds to buy back their shares. And that’s exactly what’s been happening for the past five years or so. As long as rates stay low and earnings hold up, this trend should continue.

The rewards of long-term thinking are better returns and the peace of mind that comes from being on-track to reach your financial goals. But you don’t want to be too long term. After all, as John Maynard Keynes once said, in the long run, we’re all dead.

Douglas R. Tengdin, CFA

Chief Investment Officer

Bankers to Bankers

What do central banks do?

Eccles Building in Washington, DC. Source: Wikipedia

The Federal Reserve was formed in 1914 as a way to stabilize the banking system. The late 19th century had been plagued by a series of financial panics and stock market crashes, topped off by the Panic of 1907. This was headed off by J.P. Morgan and a consortium of bankers, who set themselves up as lenders of last resort to banks that were in trouble. Newspapers at the time repeatedly reported on how Mr. Morgan was feeling, implying that a healthy J.P. Morgan was necessary for a healthy economy

This was crazy. Even back then, the US had one of the largest and most dynamic economies in the world. It shouldn’t depend on one man’s decisions—or even a small group. Other countries had central banks—bankers to the banks. When depositors lined up outside the door, the central banks could stem the tide.

So Congress established 12 regional Federal Reserve banks and an Open Market Committee to oversee the entire organization. Over time, the Fed has evolved from purely technical functions to regulatory oversight and policy management. Now it is the principal government agency tasked with maintaining the stability of our economy and financial system.

Source: Openclipart

And the system needs to be stabilized. We live in a world of fractional reserve banking. Money is created or destroyed when people take out loans or pay them down. When a bank makes a loan, it creates an asset on its balance sheet and creates a checking account deposit at the same time. The borrower uses the deposit for some kind of economic activity, and eventually pays back the loan. The faster bank loans grow in an economy, the more the money supply grows. Financial panics happen when people become convinced that they won’t be able access the deposits in their bank, so they pull them all out at once. By standing behind other banks, a central bank boosts confidence—ironically creating the conditions where people don’t see the need for a central bank in the first place.

Source: Econstories

The Federal Reserve enjoys a lot of independence. It’s actions—taking away the punch-bowl just when the party starts to heat up—are rarely popular at the time. And stabilizing good banks during a panic can look like bailouts for cronies. But sustainable economic growth requires a stable foundation. And having a safe place to keep your cash—and a reliable place to get a loan when you can use one—is pretty foundational.

Douglas R. Tengdin, CFA

Chief Investment Officer

How Preferred is Preferred?

What are preferred stocks?

“Preferred Stock Cologne” by Coty. Source: 99perfume

Preferred stocks are hybrid securities that fit between equity and bonds in a firm’s capital structure. Most of the time, if a company goes through bankruptcy, the preferred shares get wiped out. During the financial crisis, the owners of the preferred shares of Fannie Mae and Washington Mutual got nothing for their shares, while the bondholders received 100 cents on the dollar.

So in what sense are they preferred? They are preferred as to their dividend. Preferred dividends are fixed, and usually pretty high. If a company gets into financial trouble and wants to suspend its preferred dividend, it has to cancel the common dividend first. And many preferred dividends are cumulative: before a company can resume dividend payments to its common shareholders, the accumulated unpaid dividends on preferred shares have to be paid.

For years, preferred stocks lagged the financial markets. They didn’t provide the growth of common shares, since they weren’t the final residual in the capital structure. But they weren’t as stable as bonds, either. When things go wrong, preferred shareholders are often lumped together with common shareholders. They’re really super-subordinated long-term bonds. The only companies that have issued them to any great extent have been banks, where they help with certain regulatory ratios.

Until recently.

Our current yield-starved environment has touched off a feeding frenzy in preferred shares. The broad equity indices pay less than 2%; 30-year US government bonds pay less than 2.5%. Even emerging market and junk bonds don’t yield very much. So investors have been giving preferred shares another look. And so far, they like what they see. Over the past year, the S&P Preferred Stock index is up over 8.5%. And it still yields more than 5%.

This is striking, when you look at what’s in the index. Over 80% of its constituents are banks, insurance companies, and other financial firms. Essentially preferred stocks are subordinated bonds in a subordinated portion of the economy. And we know what happened to that sector during the last economic downturn. In the aftermath of the financial crisis, preferred stocks fell over 60%, and have yet to return to their pre-crisis levels.

S&P Preferred Stock Index. Source: Bloomberg

For now, though, investors can’t get enough of the high-paying shares. The assets in the popular iShares Preferred Stock fund (PFF) have grown from $14.3 to $17.5 billion so far this year – in a market with only $190 billion in market capitalization. That’s less than Pfizer’s market cap – the 25th largest US company. When one fund owns 10% of the market, the market owns that fund – not the other way around.

This is a prime example of “reaching for yield”: moving down in credit quality and out in maturity to capture more income. And it does not usually end well for the “reachers.”

Douglas R. Tengdin, CFA

Chief Investment Officer

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