Failing Upwards

What drives US markets?

Source: Bloomberg

Over the years the stock market in the US has generated significant real returns – better than most other markets around the world. Since 1994, US equity markets have returned 5.4% above inflation, while the rest of the world has averaged only 2.3%. Why?

One reason has to do with the way we treat failure. The US has a very liberal bankruptcy regime. When companies can’t pay their debts, we allow them to stay payments to their creditors and reorganize. Sometimes that means that the company continues, like the Chicago Tribune. That paper keeps coming out, despite going through Chapter 11 bankruptcy proceedings in 2007. By contrast, after Lehman Brothers collapsed, its assets were sold and the company was liquidated.

In both cases, managers were fired and unproductive assets were freed to be put to use in a more productive way. This includes buildings and equipment, but it especially includes people. When people are stuck working for “zombie companies” that have been propped up through subsidized loans, they can’t work to their fullest potential. Japan’s business sector is famous for having “company men” who draw a salary for doing nothing more than show up and read the paper. What a waste!

Failure isn’t truly failure if we learn from it and put our time and efforts to more productive use. That’s why the startup culture in Silicon Valley rewards folks who are on their third or fourth attempt. Winston Churchill put it best: “Success is not final, failure is not fatal: it is the courage to continue that counts.”

Douglas R. Tengdin, CFA

Chief Investment Officer

Euro Futures

Is the Eurozone dying?

Photo: Dave Meier. Source: Picography

It’s certainly facing tough times. Economically moribund, most Euro government bonds carry negative interest rates. Countries on the economic periphery still face crushing debt service. Unemployment remains above 10% — the same level it was shortly after the Great Recession. And soon Britain will vote to leave the EU. Who can blame them? Who wants to tie their economic future to a 20-ton anchor?

But bad as things are right now, they were significantly worse just two years ago. Unemployment was 12% and headed higher. Europe was in the middle of a double-dip recession, brought on by the central bank’s attempt to “normalize” interest rates prematurely in 2011. The Eurozone economy was shrinking by 1% per year, and had been since 2011. Now, their economy is growing, the Greek people voted to stay part of the Euro, and there is economic crisis pushing people out. Various groups might be better off by going alone, but getting there is a problem.

Eurozone unemployment. Source: Bloomberg

Absent some calamity, the Eurozone will likely continue in its present form: a monetary union with centralized regulation but most fiscal and political decisions made at the national level. The biggest threats facing Europe right now are the migration of millions of Syrians fleeing civil war and the rise of reactionary nationalist movements. Neither of these directly affects the UK, but any flare-ups over the next month will likely impact the Brexit vote.

There are lots of things to be worried about, globally, but there always are. The Euro created a unified market with over 300 million highly educated producers and consumers. It would be a mistake to bet against it.

Douglas R. Tengdin, CFA

Chief Investment Officer

Small Futures?

Are we all doomed?

Photo: Alton Thompson. Source: Wikipedia

A recent report by McKinsey and Co. discussed the long-term prospects for the stock and bond markets. Their contention was that after an era of stellar performance, returns are likely to be significantly lower over the next 20 years.

Source: McKinsey & Co

There’s nothing dramatically ground-breaking about these projections. After all, twenty years ago 10-year US Treasury Notes yielded 7%. Now they yield 1.8%. 10-year German bunds yielded 6.5%. Now they yield 0.2%. In the past, strong real economic growth driven by technological innovation and improved global trade was the source for above-average equity returns. Going forward, if economic growth remains sub-par, both equity and bond returns will be a lot lower.

German 10-year government bond yields. Source: Bloomberg

Practically, this means that people retiring in a few years shouldn’t expect a long series of double-digit returns to help them out. If they haven’t started saving, the should begin now. For younger folks, lower market levels during their earlier saving years will help them, in the long run. If you were investing all through the Financial Crisis, your best returns have come from the purchases you made in February and March of 2009, when we wondered if the global economy was headed for a depression.

But this is really a dog-bites-man story. Analysts have been warning us to expect lower returns for a while. Adapting to them means we need to save more and consume less. The highest returns over the long haul, will come from stocks, consistent with financial theory. Bonds are mainly useful as a source of stability, especially if the economy continues to grow slowly.

If returns turn out to be better than this, you’ll end up with a bigger portfolio than you expected. Stay diversified, watch your costs and your taxes, and be careful not to reach for yield. Above all, don’t panic.

Douglas R. Tengdin, CFA

Chief Investment Officer

Alpine Meadows

What comes to mind when you think of the Alps?

Photo: Kevin Connors. Source: Morguefile

Maybe it’s clear mountain lakes and crystal blue skies. Maybe it’s sun and snow and skiing. Or maybe it’s money?

A map of Europe scaled by per-capita GDP reveals an interesting tendency: the areas with the most mountainous topography tend to have higher incomes. Northern Italy, western Austria, southern Germany, and Switzerland are all significantly richer than other regions. This holds true despite differences in taxation, culture, transport, and trade policies. Why might this be?

Source: Eurostat

Many explanations have been offered—the tendency for mountainous areas to be left alone; the impact of global tourism; even the legacy of the Hapsburg Empire, remote though that may be. (Without Wiki I can’t recall the name of single Hapsburg leader.)

What jumps to mind when I see this map is the connection with Switzerland. What’s distinctive about the Swiss? Switzerland has fiercely guarded its independence and neutrality. It was never a great manufacturing center, but over the centuries their safe-haven status has helped them amass a large base of capital. That money had to be employed productively. So the regions that had the greatest contact with Swiss bankers and banking institutions have had more access to ready sources of capital and finance. It also didn’t hurt that Switzerland has been a self-governing coalition of small states from the time of William Tell.

Statue of William Tell in Altdorf. Source: Wikipedia

As our bureaucrats and politicians try to sort out too-big-to-fail banks and banking regulations, it’s worth asking what’s made Switzerland so stable for several centuries. Finance is real. It’s a mistake to treat it as something extraneous to the economy.

Douglas R. Tengdin, CFA

Chief Investment Officer

Book ‘Em

Why do we love old books?

Photo: Diane Hope. Source: Morguefile

There’s something romantic to “old book smell.” It’s a kind of earthy, musty aroma of old leather and paper. Maybe the smell invokes trips to the library when you were a child. It’s quite attractive to many people. There are even high-end perfumes that try to mimic it.

Paper products release distinctive odors as they break down, notably lignin, which produces a vanilla-like scent as it decomposes. Various presses use different sources of paper which have particular characteristics. My old paperback copies of Lord of the Rings have a wonderful smell of birch or pine to them. It’s even possible to date a volume by smelling it. Scientists have identified dozens of volatile organic compounds produced by old paper.

It’s one reason I hope e-books never wholly replace traditional paper books. Yes, I can easily adjust the font size on my Kindle as my eyes get older, and yes, I can access and carry hundreds of volumes in a device lighter than a sweater. But a glass-and-plastic reader doesn’t entice me the way an old volume does. It can’t exude the ambiance of the family library, even if they infuse lignin and rosin into the simulated leather cover.

Photo: Gabor. Source: Morguefile

Our world gets more digitized and more accessible every day. It’s important, though, to remember what makes it truly humane. For me, old books will always be part of that picture.

Douglas R. Tengdin, CFA

Chief Investment Officer

Getting Going

How do you get started investing?

Photo: Tyler Main. Source: USMC

I got involved with investing via a different route. I had studied computer modeling in college in the early ‘80s. While looking for a job, I met with a bank manager who had a computer model for the bank’s earnings and balance sheet, but didn’t have anyone that could run the model. Tentatively, he hired me to implement the computer simulation. I got the analytic software to work much faster than expected, so he put me onto different tasks. I quickly learned how important investments are on a bank’s balance sheet—how they can be used to help a bank match its assets to its liabilities.

Essentially, I came to investing by studying liabilities. And that’s not a bad approach. The reason we invest is to meet future financial needs—our future liabilities. For example, at some point, most of us want to retire. We’ll need a source of income to live on. That future demand is a liability, so we save and invest now in order to meet that need. The amount of time we have until we need the money will help determine how much risk we can take—how much volatility we can put up with in our portfolios.

Every investor is different. We all have unique needs, wants, and dreams. We also have varying resources: our jobs, skills, and relationships. These combine to create a distinctive asset/liability structure—our extended personal or family balance sheet. Your investments are just part of this picture, and the part you probably have the most control over. That’s why investments are like clothes—there’s no “one size fits all.” They have to be cut and fit to match the unique size and shape of your individual balance sheet. (It’s also why I’m skeptical that robots will turn out to be very good tailors. But that’s a different discussion.)

Tailor’s shop. Photo: Wolfgang Sauber. Source: Wikipedia

The first rule of investing is to “know yourself.” Before we buy a stock or think about asset allocation, we need to understand what we own and what we owe: our assets and liabilities. Only then can we match our investments to our lives—and have portfolios that fit.

Douglas R. Tengdin, CFA

Chief Investment Officer

Brexit Blues

What is “Brexit”?

River Thames. Source: Wikipedia

“Brexit” refers to the potential withdrawal of the UK from the European Union. They’re voting on the possibility on June 23rd of this year. The UK isn’t part of the Euro – the British Pound is still their currency. But it is part of the EU, and has been part of that or its predecessor, the EEC, since 1973. Membership in the EU has certain pluses and minuses. It improves trade, makes investment easier, and reduces the cost of most items. On the other hand, it requires large membership fees, puts the Brussels in charge of many restrictive labor and environmental rules, and has cost some Britons their jobs. The campaigning on this issue has been intense.

Photo: Dean Molyneaux. Source: Wikipedia

If Britain votes to leave the EU, it will be another step in the dissolution of many economic and political deals that have tied the world closer over the years. It would make “Grexit”–the potential exit of Greece from the Euro–more likely. Scotland and Wales might reconsider leaving the UK. The UK would have to renegotiate a host of trade deals with Europe and the US, and the terms would likely be more restrictive. A more risk-averse investment climate would likely drive the US dollar higher and US interest rates lower. This, in turn, could push China to devalue the Yuan. In short, global markets could be quite volatile.

Brexit, Grexit, and the rise of nationalist and nativist tensions in the US and around the world are symptoms of a general unhappiness with the pro-trade and pro-globalization order that has grown since the fall of the Soviet Union. Improvements in global commerce have led to stronger economic growth, but many people’s lives have been disrupted in the process.

The UK has reconsidered ties with Europe several times before. Each time, they have voted overwhelmingly to stay close to the Continent. Let’s hope they do so again.

Douglas R. Tengdin, CFA

Chief Investment Officer

Stock Market Values (Part 4)

How do you value a company when there are no earnings?

Photo: Mary R Vogt. Source: Morguefile

Is it just a case of irrational exuberance? Not necessarily. Traditional discounted cash flow analysis is a useful tool when it comes to evaluating financial assets, but it has its limitations. One aspect of investing that DCF analysis ignores is management’s flexibility. They can delay bringing a product to market, or expand its production to meet an unexpected surge in demand, or shift how their facilities are used—perhaps to produce a different kind of product. This kind of flexibility has real value.

To capture this value, we use option-pricing methods to supplement traditional valuation. An option is an asset that can go up, but is limited to the down-side. If management possesses a patent on a new drug, that patent has value even though it’s not producing cash right now. The upside may be huge, while the downside is limited to the cost of bringing the medicine to the marketplace.

Call option pricing. Source: Wikipedia

This is also why many tech companies seem to persistently carry such high valuations. The market is putting a high value of their potential growth, and the flexibility management has to pursue different approaches to their business. Putting a value on this kind of asset—management flexibility—is difficult, but it can be done. It depends on the cost of exercising the flexibility, the potential upside a change could realize, the amount of time management has to make the decision, and how volatile conditions are. The more volatile things are, the more these options have value. These values can all be quantified in a pricing model.

Black-Scholes Option Pricing Formula. Source: Wikipedia

In practice, this involves a lot of assumptions about stock prices and strike prices and market volatility run through an analytical model with decision points and normal distributions. Additionally, the real world will insert complexities that our models can’t accommodate. Nevertheless, options methodology is essential for understanding why some money-losing companies still have high market values, and why some profitable companies seem so cheap. Today, it seems, the market is putting a lot of value on the options that internet-media companies like Amazon and Netflix possess.

It’s not necessarily irrational just because you don’t understand it. Sometimes, what is unseen is more important that what is seen. It’s all in the options.

Douglas R. Tengdin, CFA

Chief Investment Officer

Federal Reserve Reservations

Federal Reserve Reservations

It’s all good.

Eric Rosengren, President, FRB Boston. Source: FRB Boston

That’s what Eric Rosengren, President of the Federal Reserve Bank of Boston assured about 150 business leaders from the Concord area last week. Rosengren has spent his entire career and the Boston Fed. He got a BA from Colby College and a Ph.D. from the University of Wisconsin – Madison in economics. He joined the Fed as an economist right out of graduate school, and ran the research department as well as the bank examiner’s office.

Rosengren has spent his professional life working with macro-economic data. He knows his way around labor force participation rates and potential GDP growth. Rosengren is a smart man. So when he says that the financial markets are too pessimistic in their view of the US economy, we need to pay attention. After all, the data show our economy is growing steadily, if slowly. A growing economy should see interest rates move back towards normal.

But there are feedback loops in the economy that aren’t immediately apparent in the data. With the US economy growth faster than its trading partners, the dollar is strengthening. Any move by the Fed to raise rates only pushes the dollar higher. Currency vigilantes seem to have replaced bond vigilantes in the present environment. A higher dollar does several things: it crimps US exports; it reduces tourism here—along with tourist purchases at retail outlets; it raises the price of oil everywhere else in the world; it makes it more difficult for emerging economies to service their dollar-based debt. The dollar acts as a force-multiplier for interest rate policy.

Trade-weighted US Dollar. Source: Bloomberg

When President Rosengren was asked what he thought his personal data-biases might be and how he corrects for them, he assured the audience that he was data-dependent—that working with objective, quantitative indicators will counter his natural dovish tendencies. He noted that he had dissented twice in policy votes—both times voting for lower rates. It’s all good, he assured us. The data will set us free.

But data are never objective. They have their own inherent biases. We know cell phones and caller ID have made political polling problematic. Why should economic surveys be any different? We know that there is a status-quo bias in all measurements—that they tend to miss new developments. And—with all due respect—President Rosengren has never had to meet a payroll. It seems that he is underestimating the disruptive effects of the financial crisis and ensuing recession. Businesses that saw their credit lines revoked—and had to lay off thousands of workers as a result—won’t have “normal” animal spirits. It will take a while for them to borrow and grow as if the rest of the world has gone “back to normal.”

A lifetime spent calculating equilibrium interest rates and managing research departments might make you a good analyst, but may not help you see how the economy is changing—how the data themselves distort our view of what’s going on. For that, you need real-world experience. When you stare too long at any set of numbers, sometimes all you get are spots in front of your eyes.

Douglas R. Tengdin, CFA

Chief Investment Officer

Stock Market Values (Part 3)

Now what?

Photo: Dave Meier. Source: Picography

Once you have a sense of a firm’s business-lines, how do you put numbers on those realities? Financial theory states that the fair value of an ongoing business is the present value of its expected cash flows. This requires that an analyst estimates the cash flows, the discount rates, and how fast a company can grow. Simple, right? All you need to know is the cash from here to eternity.

That’s the rub. Because nothing ever works out according to plan. So we use probabilities and higher discount rates to account for the risk. We also need to estimate the growth rate. On paper, accounting for all these variables can look intimidating.

Source: CFA Institute

In theory, this looks like a lot of advanced math. But in practice, it’s actually pretty simple. The way a only way company can increase its value is to increase the level of cash flow available to investors. It can do this by increasing sales, decreasing expenses, or decreasing the cost of capital. Of these three, increasing sales is the only sustainable way to grow, since costs can’t fall below zero.

This is why the market value of a stock may fall even after they report a bang-up quarter. The market is more concerned with their prospects going forward, and how sustainable those prospects may be. The reported results are simply history—a way to evaluate management’s credibility, if they hit their numbers or not. History isn’t bunk, but it is in the past. What matters to investors is the prospect for future cash flows.

There are no shortcuts in valuation. Either a company can pay money to is owners or it can’t. In the end, valuation depends on value-added.

Douglas R. Tengdin, CFA

Chief Investment Officer

Douglas Tengdin's Global Market Update