A Few Quick Thoughts …

In no particular order:

Source: Econlib

Scottish independence: the conventional wisdom is that Scotland will now have a referendum and vote to leave the UK and re-join the EU—even the Euro-zone. This will be messy. During the last Scottish independence vote, they wanted to immediately adopt the Euro, but Brussels said the Scots would have to apply like any other nation—a process that would take years. A new independence referendum must be authorized by the British—not Scottish—Parliament. They’re going to be pretty busy. I don’t think we will see an independent Scotland anytime soon.

European Euroscepticism: the Brexit vote strengthens the hands of those who want to see “Frexit” in France, “Nexit” in Holland, Czexit, and so on. Demands for referenda around Europe will only go up. The combination of economic stagnation at home and radical Jihadism coming from the Middle East feeds a nationalistic xenophobia that is anti-trade and anti-capital.

Interest Rates: the 10-year UK Treasury Note now yields less than 1%–down from over 2% at the end of last year. Interest rate cuts and quantitative easing from the British central bank are now likely. This—along with a falling Pound—will support the UK economy. It may stumble—after all, everyone’s going to pull in their horns a bit here—but their economy won’t fall off a cliff.

Takebacks: there are reports of people who want a Brexity do-over, who voted thinking that their “Leave” vote would lose, who just wanted to send a message. So many UK voters have signed a petition on the House of Commons website for another vote. But unless the petition gains more signatures than there were “Leave” votes—17 million—there will be no second referendum.

Silver linings: it’s possible the Brexit vote will lead to a growth in free commerce between the UK and the US, Canada, Australia, and New Zealand. The EU is statist and anti-democratic, after all. But if the forces that won Brexit did so by appealing to anti-trade sentiment, a pro-trade outcome seems unlikely. Ditto for a de-regulated City of London attracting more global banking. That’s whistling past the graveyard. “Leave” means leave.

Lehman: is this a “Lehman moment”—comparable the Lehman bankruptcy during the Financial Crisis? Like Lehman, it caught most people by surprise. Like Lehman, it was part of a larger trend. And like Lehman, there are broad implications, many most of which we don’t understand, yet. But unlike Lehman, this won’t take down the banking system. A referendum is a vote, and requires enacting legislation to implement any changes. This will take time. There is no web of short-term debt to cause a cascade of insolvency. But political contagion across the rest of Europe is possible.

Bottom Line: Brexit is neither the first nor the last word on de-globalization, Euro-skepticism, and nationalist populism. But it is the loudest voice heard so far on the global stage. And that voice is calling for change in the status quo. Uncertainty is increasing, and most investors will be looking for safety. But the best returns will come from taking careful, prudent risks.

Douglas R. Tengdin, CFA

Chief Investment Officer

Brexit Blues

After the Brexit vote, will London Bridge come falling down?

Source: Morguefile

Like most observers, I was surprised by the Brexit vote. Yesterday the betting markets in London had the odds of a “Leave” vote at 25%. This morning, European markets are adjusting to the new reality: UK shares are down 5%; German and French stocks are down a little more; global interest rates are falling as investors look for shelters from the coming market storm.

EU leaders will meet next week in Brussels to determine what happens next. The most cogent economic argument that the “Leave” campaign had was that the UK would be better off if it didn’t tie its financial future to a troubled Continent. The current government, which was pro-Remain, will resign, creating a great deal of political uncertainty. Eurosceptic forces in the rest of Europe will be strengthened by this development.

UK Referendum Map. Red = Leave. Source: Politico

The result will now trigger a two-year disentangling process where London and Brussels will negotiate the terms of a messy divorce. For US companies that use the UK as a staging ground for entry into the rest of Europe, the vote will bring hard choices about what to do next. The “Leave” vote means the British access to the European market will be impaired.

This vote is consistent with the trend of de-globalization and economic populism that has grown in recent years. There are a lot of folks who have been left behind by the current economy; there are “two Americas” as well as “two Britains” and “two Europes.” The “Leave” vote will strengthen the dollar, depress interest rates, and roil the markets—something that the populists seemingly welcome—“shaking the Etch-a-Sketch.”

In the midst of the turmoil, it’s important to remember: even if the political map changes, the global economy will largely continue as it has. BAE will still build the Harrier; London will remain a center for currency trading; the UK is still the 4th largest economy in the world—although now they will have to re-negotiate their trade arrangements. But countries don’t trade with other countries—people and companies trade with one another. Governments simply assist or impair that process.

Hopefully, the British people—as well as the global markets—will take to heart the message of the old World War II poster: “Keep Calm and Carry On.”

Source: Wikipedia

Douglas R. Tengdin, CFA

Chief Investment Officer

The Myth of New

The Myth of “New”

We’ve never seen this before!

Meerkat. Source: Animal Photos

That’s what people say when they run into a novel situation. Whether it’s Brexit or Venezuela’s economic meltdown or Puerto Rico’s default, people want to marvel at their situation’s unique status.

But there’s nothing really new under the sun. The writer Malcom Muggeridge once observed that there’s no new news, just old news happening to new people. Take the immigration crisis in Europe. While millions of people coming into Europe from Syria is a new development, wars have always generated refugees. It’s partly why so many people moved to the United States in the late 19th century. Our economy boomed—the additional labor helped run factories in the cities and settle the frontier.

Source: Eurostat, Wikipedia

While the latest developments may be new to many news reporter, they’re unlikely to be truly unique. History may not repeat itself, but it does rhyme. So don’t let alarmist headlines freak you out. As Calvin Coolidge once said, if you see ten troubles coming down the road, you can be sure that nine will run into the ditch before they reach you.

Douglas R. Tengdin, CFA

Chief Investment Officer

The Myth of Equilibrium

Will we ever get back to normal?

Photo: Reza Tizz. Source: Morguefile

Everyone wants the economy to normalize—normal interest rates, normal economic growth, normal inflation. But we never seem to get there. Something always seems to come up.

Ten years ago, the wheels came off the bus with the housing boom and financial crisis. Five years ago we had a Euro crisis and fears of “Grexit.” Now it’s “Brexit” and the most bizarre presidential contest in memory. Economists are debating whether we’re in a “new normal” or secular stagnation or if the rising “gig economy” will turn us all into innkeepers and taxi drivers.

Some see the market as an evolutionary mechanism, gradually adapting to change. But I see it as a complex ecosystem, with stresses that come from invasive species, severe weather, over-harvesting, and all kinds of other factors. If you walk into a forest, nothing is really stable. It’s always in a transition from something old to a new new thing.

I don’t believe in a past, present, or future economic equilibrium. The economy we see is the economy we have to work with. The market is always shifting, violating the most nuanced and elegant models. The market doesn’t do elegance. If you want elegance, go see a tailor.

Douglas R. Tengdin, CFA

Chief Investment Officer

Borrowing the Future

Are young people being eaten by their student loans?

Source: St. Louis Fed

The outstanding level of student loans has increased by 10% per year for the past 9 years. The amount student borrowing has grown from about $540 billion in 2007 to over $1.3 trillion now, surpassing the level of credit card and auto loan debt. With college enrollment increasing and the cost of college rising, this balance is only going to grow.

On one level, this is encouraging: kids are investing in themselves at an increasing rate. In our dynamic knowledge-based economy, people have to have advanced skills to improve their chances of getting and keeping a good job. On another level, however, it is concerning. The heavy debt-loads assumed by students and their parents may be crimping the economy—discouraging folks from other kinds of economic activity. Among people under 30, over almost half have student loans to pay off. And much of the increased spending on college is just going to price increases, although lately the rate of tuition hikes has been slowing.

Year-over-year increase, college tuition and fees. Source: BLS

Not all student debt is productive. With college enrollment rising, graduation rates have been falling. At many schools, less than half the freshman class receives an undergraduate degree. If students don’t graduate, they’re not much better off in the job market than folks with no college at all. So delinquencies on student loans have been rising. Currently, about 20% of student loans nationwide are delinquent—adjusting for those that are still in their deferral period, where no payments are due. For the past two years, though, the delinquency rate has been stable.

There’s no evidence right now that we’re in a student loan “crisis”—although, with annual tuition and fees that exceed many families’ annual incomes, some folks are in over their heads. People need to take “buying” an education seriously. For the amount of student debt they incur, many young people could own a small house. But there’s no re-sale value for three quarters of a college degree. You can’t sell the asset and pay off the loan.

Source: cambridgeusa.org

Student debt is a necessary evil. We have the best colleges and universities in the world, in part because they compete with one another for students, grants, and faculty. For low-income students, the most economical choice is to take their first two years at a local community college, then transfer to a state school—hopefully one within commuting distance.

But an undergraduate degree isn’t necessary for all occupations, and it shouldn’t be used as a marker to screen applicants. For many, college is an unforgettable experience. But as Dear Abby once wrote, if we could sell our experiences for what they cost us, we’d all be millionaires.

Douglas R. Tengdin, CFA

Chief Investment Officer

Growing, Growing, Gone

Is growth worth it?

“Enchanted Forest.” Photo: Dave Meier. Source: Picography

We live in a deflationary time. Excess investment in productive capacity has provided more and more goods at cheaper and cheaper prices. Global trade and technology means that the marginal cost of labor minimal. Even professional services will be affected by globalized labor. The Microsoft-LinkedIn merger means that there will be millions of human “Clippies” waiting for us inside our Word or Powerpoint files, offering to do our animations and graphics or edit our documents for just a few dollars.

“Clippy.” Source: Wikipedia

Falling prices for goods and services around the world means that future money is more valuable than it is right now. It’s the opposite of an inflation problem. It’s why interest rates are so low right now. It’s also why safety is so important. Deflation creates credit issues for everyone except sovereign borrowers. In an age of deflation, countries can print their own currency without the normal inflationary worries.

The increased value deflation puts on future cash flow is why companies that can squeeze a little growth out of a depleted economy’s toothpaste tube have such high valuations—some of them eye-popping.

Source: Finviz

(The 40 “PE” for US Treasuries is just the 2.5% yield on 30-year bonds inverted, so that it is comparable with stock market price-earnings multiples.)

This helps explain why growth companies have outperformed value for the past several years. Deflation puts a premium on growth, because future cash will be worth more, if deflation continues. That of course, is the rub. Nothing continues indefinitely. As a Greek writer noted 2500 years ago, the only constant is change. No one steps into the same river twice.

Investors, policy-makers, and businesses have placed their bets that the economy will change back towards “normal”—towards 2% inflation and 1.5% economic growth. When we read the Fed’s minutes and speeches, it’s clear that committee members are concerned that inflation will pick up soon and they will have to raise rates rapidly to avoid falling behind the curve. They fear this would be disruptive.

But the that was the issue 20 years ago. Resources would get scarce and push prices higher, lifting inflation and inflation expectations. Now excess capacity is lowering prices, leading to deflation and putting a premium on growth. And what if deflation intensifies? We know things will change. But which direction with they go?.

Science fiction writer William Gibson says, “The future is already here—it’s just not evenly distributed.” With inflation and deflation both vying for significance, we don’t know what future that will be.

Douglas R. Tengdin, CFA

Chief Investment Officer

Rating Agency Issues

Can the ratings agencies be saved?

Blind Justice. Photo: Itojyuku Themis. Source: Wikipedia

Investors, companies, and regulators all benefit from having a cheap and easy way to measure credit risk. There are all kinds of institutions with a public mission that need to invest in bonds, and they need their bonds to be low-risk. Investment-grade or A-level credit ratings provide this. But the credit agencies are paid by the bond issuers—a clear conflict of interest. Can this be solved?

This conflict has been with us a long time. It became significant when the agencies succumbed to the collective insanity from 2004 to 2007—some bonds were rated ultra-safe that never should have been issued. Banks, pension funds, towns, and insurance companies all suffered losses.

This issue—the agency issue—is the same problem that accountants, newspapers, psychologists, and just about all professionals have. It’s hard for people to criticize someone if that person is paying them. The professional would be acting against his own interest; the people paying don’t usually like to be criticized.

Take auditors. In the light of Enron, we were shocked, shocked that their accountants helped conceal Enron’s fraud. But Enron was a plum assignment, yielding millions in consulting contracts. The partners at Arthur Anderson were getting rich. Or newspapers: has a critical story ever been spiked because the subject of the criticism buys a lot of ads? Of course it has. The writer Upton Sinclair used to say that it’s difficult to get someone to understand something when their salary depends on not understanding it.

Principal-Agent Problem. Source: Wikipedia

There has never been “golden age” where independent professionals completely subjugated their personal interests for the greater good. Everyone is conflicted in one way or another. The solution lies not in greater regulation but in more competition and more transparency. When a competitor stands to benefit if you fib on behalf of a client, you tend to be more careful.

Professional agencies need to take the agency problem seriously. But everyone’s an agent. We need to admit this and disclose our conflicts.

Douglas R. Tengdin, CFA

Chief Investment Officer

The Irrelevant Federal Reserve

What if they had a Fed meeting and nobody cared?

Janet Yellen at her press conference. Source: Federal Reserve

The FOMC had been trying to talk up rates for the past two months. Some notable policy doves were commenting that the market had it wrong—that interest rate expectations were too low, and that we should expect two or three rate hikes this year. Even Chair Yellen got in on the act. In May, she noted that long as the economy continues on-track, the Fed would continue to normalize rates.

FOMC Member “Dot Plot” 6-15-16. Source: Federal Reserve

That was then, this is now. The employment report threw a big bucket of cold water on those plans. The latest report was “disappointing,” Yellen noted. There has been a loss of economic momentum. While we shouldn’t pay too much attention to one data point, they can’t ignore broad economic indicators that are cautionary. Yellen claims that the Fed is data-dependent. So when dovish data come in, they have to re-think their position.

So who’s in charge? During a two-minute period in her press conference, she used the word “uncertain” or “uncertainty” at least five times. The Fed and the market are on the dance floor, but neither knows whether to put their hand on their partner’s shoulder or around their waist. No one knows who’s leading.

Illustration: Henriq Bastos. Source: Morguefile

All the Fed officials have been talking about normalizing rates. But their talk is aspirational: it’s more about the Fed’s hopes, and less about their plans. They aren’t leading, but they do have a $5 trillion balance sheet and an unlimited checkbook. That’s more than anyone else. We don’t want to get on the wrong side of that.

As long as we’re stuck in a slow-growth economy with no growth in manufacturing, mining, and energy jobs, we’ll feel unsettled. Janet Yellen claimed yesterday that every meeting is live, that rate changes are always possible. But given the lack of leadership, it seems that the Fed is increasingly irrelevant.

Douglas R. Tengdin, CFA

Chief Investment Officer

The Biased Investor: Putting It Together

The Biased Investor: Putting it Together

So how many are there?

Blind Men Appraising an Elephant. Edo Period Illustration. Source: Brooklyn Museum

How many mental mistakes can we make? We’ve discussed loss-aversion, overconfidence, herd behavior, and all kinds of cognitive biases. But there are lots more: Wikipedia lists over 150 different kinds of mental errors, from anchoring to the money illusion to the zero-sum fallacy. People are intuitive thinkers. Often, there just isn’t time to think things through. If an oncoming car changes direction and starts to head towards me, I need to get out of the way NOW—not after I’ve calculated his speed and direction and how close the nearest hospital is. But our intuition is imperfect, and leads to less-than-ideal outcomes.

In general, there are three types of errors: those that come from our own beliefs, those that come from being part of a group, and those that come from our distorted memories. You could say that individual errors tend to cancel each other out when a broad and diverse market has developed. But when social biases and herd behavior come into play, the entire market can appear to be rushing off a cliff. Crowds have their own dynamics.

Photo: Kashfi Halford. Source: Wikipedia

Cognitive errors can cost us dearly. Whether our loss-aversion leads us to underinvest, or our homeward bias causes us to favor companies from our region, our portfolios tend to reflect these systemic issues. What can we do about them? One part of the answer is to slow down. High frequency trading may work in milliseconds, but most investment opportunities are around long enough for you to examine the business case. Take the time to do some research. If someone tells you that a fund is closing soon and you need to decide immediately, it’s probably better to walk away. A high-pressure sales pitche and rational calculation don’t go together.

Second, leave some margin for unexpected developments. It’s been said that markets are random, but really, it’s the news that’s random. I may buy shares of GE because I like their financial position, their business model, and their management team takes shareholders seriously. But if the CEO announces he has cancer tomorrow, that’s a piece of news I can’t plan for—and the stock will likely go down with the uncertainty that such an announcement would create.

Finally, stick to your own investment plan. Investment strategy has to do with our personal goals and constraints—what return we need, how long we have, what legal restrictions there might be, and so on. Our strategy doesn’t change because the market is over or under-valued. Even if an investment is a genuine bargain, it might not be appropriate for you. Your plan should be tied to your total financial picture.

Markets aren’t totally rational. They’re made up of people, and people aren’t rational. We’re affected by our emotions, our memories, and the shortcuts we use in our thinking. But if we take the time to think things through, we’ve got a better chance to reach our objectives. And that’s the unbiased truth.

Douglas R. Tengdin, CFA

Chief Investment Officer

[cognitive biases, herd behavior, planning]

The Biased Investor: With the Benefit of Hindsight

It’s all so obvious. Isn’t it?

Photo: Aimee Low. Source: Morguefile

That’s the way everything looks when you look back. When we examine the market of the late ‘90s, it’s “obvious” that tech stocks were in a bubble and overpriced. When we look at early 2009, it’s “obvious” that the world was on sale, and that great companies could be bought for a fraction of their true worth. When you look at the past year, it’s “obvious” that the market has lost momentum and is due for another correction. Isn’t it?

But that’s looking backwards with the benefit of experience. We know how things turned out, so the path seems self-evident. We call this “hindsight bias,” and it affects our memories. Jurors in malpractice cases often conclude the doctor should have known the outcome would be bad because they already know how things turned out. After 9/11 or other terror attacks we conclude the authorities should have known about the killers and done something, because we already know about the tragedy.

In reality, the future is never clear. In the ‘90s we didn’t know if revolutions in technology would continue to make us more productive and boost economic growth, or if they would flame out in a wave of enthusiasm. During the Financial Crisis we didn’t know how bad thigs really were inside the banks’ balance sheets, and whether the government would have to nationalize a third of the stock market to keep the economy going. Today, we don’t know if China’s economy will collapse under the weight of its growing bank loans, or if concern about terror attacks will cause US consumers to pull back—pulling everything down with them.

China bank loan totals (billions, USD). Source: Bloomberg, National Statistics Bureau (China)

Investing isn’t like driving across the country. We don’t have signs with big arrows telling us which way to turn. The future only exists as a range of possible outcomes, with some developments more likely, and some less likely. And sometimes freakish, once-in-a-lifetime things happen—black swans, or white swans—that change everything.

In Arabic, there’s a word that describes a deterministic worldview: “maktub: it is written.” It means that the outcome has already been decreed and recorded by God. But investors don’t have access to these decrees. We have to look at the world probabilistically. Nothing is obvious. If the future is written, it’s written in invisible ink.

Douglas R. Tengdin, CFA

Chief Investment Officer

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