Digging Deeper

Why do commodity prices keep falling?

Photo: Pedro Perez. Source: Morguefile

The world is awash in oil right now. And it’s the same story for copper, zinc, and a host of other industrial materials. The price of oil is down 60% from its peak last year; a broad-based index is down almost 30%. What’s going on?

Part of the answer has to do with the dollar’s status as a reserve currency. The US is doing better than the rest of the world, so interest rates are going up here, while they’ve been falling almost everywhere else. Most commodities are priced in dollars, so in order to compensate for the dollar’s rise, their prices have to fall—just to keep from going up in non-dollar terms.

Part of the explanation has to do with China. For the last three decades, China has developed at an amazing rate—using exports to leverage its economy on the rest of the world’s growth. But China is now a $10 trillion economy. Unless they find interstellar markets for their goods, there are limits to how much they can sell outside their borders. They have to transition from an outward-oriented manufacturing economy to an inward-focused service economy. That leaves a lot of capacity—that previously fed China’s growth machine—looking for new markets. And those firms have been cutting their prices.

China GDP. Source: Bloomberg, World Bank

And part of the fall in metals prices has to do with the entrepreneurial nature of a capitalist system. When prices fall, production is supposed to fall as well. But this doesn’t happen right away. A lot of large and small companies borrowed money to expand capacity when prices were high. When prices fell, smaller companies increase their output, trying to bolster revenues in order to service their debt. And bigger companies—with less debt—hope that by driving prices lower they can put their smaller competitors out of business—and maybe scoop up their assets in bankruptcy court.

Eventually, these transitional factors will reverse themselves, and production will fall. Supply and demand have to balance; markets eventually clear. Short-term effects are not the same as long-term effects. But suppliers will have to get through the short-term storm to reach the growing global market that is over the rainbow.

Douglas R. Tengdin, CFA

Chief Investment Officer

Golden Fetters?

Every few years someone suggests we return to a gold standard.

Source: Pixabay

It’s an election year, so discussions about money, the Fed, deficits, debt, and the gold standard are bound to come up. For millennia gold served as medium of exchange, unit of account, and store of value. As the densest material in the world, it’s fairly easy to determine its purity. Politicians often suggest tying the currency to something—in order to restrain the government’s ability to print money at will. But economists almost uniformly reject the idea of a gold standard. Why?

In its early years, the US was on a bimetallic standard. Banks issued their own notes that were convertible to gold or silver on demand. The government set the standard by which gold and silver could be exchanged for one another. During the Civil War, the government suspended convertibility and issued fiat money. In 1873, we resumed convertibility, but only into gold. Countries around the world had adopted a gold standard, and this uniformity facilitated global trade.

McKinley runs for President on the gold standard. Source: Wikipedia

But the fixed standard created problems. During boom times banks would issue far more notes and deposits than they had gold in reserve. When the economy slowed and people demanded their money back, banks failed, credit contracted, and the economy fell into a recession. The US had at least four bank panics and one depression between 1872 and the creation of the Federal Reserve in 1914.

The main problem, economically, wasn’t boom/bust nature of the gold standard, though. It was the fact that an increasing percentage real resources were devoted to a creating a monetary unit. During the California Gold Rush and the Klondike Gold Rush, farms and factories around the country were vacant, as men caught “Yukon Fever” and went off to grub in mills and mines. The same problem would plague Bitcoin if it ever became a widespread mode of exchange.

Price of gold in real and nominal terms. Source: Wikipedia

In the long run, economies grow faster than gold can be extracted from the earth. Prices will tend to fall, and the value of money rises. When the value of money goes up, the price of goods and services is falling. This is deflation, and it leads to hoarding—people receive a real return just for holding money. There is little incentive to put money to work—and at risk—in the economy. Productivity and living standards inevitably fall. This is one reason the US closed the gold window in 1971.

Most importantly, the gold standard is the solution to the wrong problem. Folks are rightly concerned about the temptation for government to abuse fiat money—printing more than the economy needs in order to finance excessive spending. That kind of behavior has inevitably led to hyperinflation, from post-Revolutionary France in the 1790s to Zimbabwe in 2009. But the problem today isn’t inflation, it’s deflation. We don’t have too many dollars chasing too few good. We have too much stuff chasing too little money.

In the end, the gold standard served a purpose as the world became more interconnected through global trade and capital flows. Now that the global economy is already tightly interlinked, it would be a mistake to tie the world’s largest economy to a limited supply of money. And if the Fed has discretion to change the monetary exchange rate for gold–as it did in the ‘70s–that effectively puts the economy on a Fed standard—exactly where we are right now.

Douglas R. Tengdin, CFA

Chief Investment Officer


What causes unemployment?

Unemployed men outside soup kitchen. Source: Wikipedia

The unemployment rate is falling. It’s down to 5%–half of what it was during the recession in 2009. Most economists consider 5% the natural rate of unemployment—the rate that accommodates a dynamic, changing economy, where employers hire and fire and where people change jobs. With the rate falling and wages rising, it looks like the Fed is about to raise interest rates for the first time in over 8 years.

Unemployment Rate. Source: Bureau of Labor Statistics

But what causes unemployment in the first place? That’s the question that vexed economist John Maynard Keynes in the ‘30s, and that prompted him to formulate his General Theory. He proposed that a decline in aggregate demand will lead to lower spending for new goods. Businesses will then lay off workers, since they don’t need to make as many goods. This is why we use monetary and fiscal policy today to try to jump-start the economy.

But the whole notion of unemployment is a modern invention. In the 18th and early 19th century, we had primarily an agrarian economy. The vast majority of the labor force worked on farms—and farmers always have more work to do. With the industrial revolution came factories, mills, and specialization. It was possible to get laid off from your job—the factory could close, or new technology could displace workers. That’s why the Luddites and Saboteurs tried to destroy the machinery that threatened their jobs. But the word “unemployment” doesn’t appear with any frequency in English literature until after 1900.

Word frequency. Source: Google Ngram Viewer

Of course, this may be an artifact of measurement. There has always been concern about the potential mischief that “idle hands” might create. But unemployment didn’t become an issue of public policy until the early 20th century.

Still, the Bureau of Labor Statistics was created in 1884—just as the labor movement was getting going. And it’s been estimated that unemployment hit 12% during the monetary depression of the 1890s. But it’s worth remembering that our notions of unemployment and under-employment are creations of a modern economy. As we enter the post-modern era, that could change.

Because there’s always more work to do. The question is, who will pay you to do it?

Douglas R. Tengdin, CFA

Chief Investment Officer


Why do people climb mountains?

Photo: T. Nichols. Source: Morguefile

90 years ago British climber George Mallory famously answered: “Because it’s there.” It could be for the challenge to body, mind, and spirit that mountains represent. It could be for the exercise and fresh air. Or it could be for the status.

A couple of journalists have been cataloging Himalayan expeditions, and their data provide evidence that people do climb for the bragging rights. Over the years, there have been over 1000 expeditions to Everest, the world’s highest peak. The next seven highest mountains in the Himalayas—part of the prestigious “8000-meter group”—have seen an average of 260 expeditions. And the next eight-highest peaks—just below 8000 meters—have seen, on average, only 20 expeditions. The arbitrary 8000-meter threshold is a magnet for summit attempts.

And you don’t’ have to go to extremes. In New Hampshire, thousands of hikers have climbed all 48 4000-ers—peaks that rise above 4000 feet above sea-level. They’re called “peak-baggers.” Mountains just below 4000 feet see far less foot traffic.

Franconia Range in the White Mountains. Photo: Doug Tengdin

It may not be for bragging to others—people may just want to be able to tell themselves that they’ve reached the Earth’s highest point, or have hiked a 4000-er. We’re status-seekers, and sometimes the status is internal. This has important investment implications. In the long run, finance is rational. Money doesn’t care who owns it. But in the short-run, our behavior is non-rational. We buy and sell assets for all kinds of reasons, which include status.

Investors need to act rationally. Bragging won’t help us reach our financial goals. “Because it’s there” may be an adequate excuse to bag a peak, but it’s not a good reason to buy a bond or stock.

Douglas R. Tengdin, CFA

Chief Investment Officer

Your Brain on the Market

Can we think our way to better performance?

“The Thinker,” Rodin Museum, Philadelphia. Photo: Andrew Horne. Source: Wikipedia

There’s an enduring misconception that we only use about 10% of our brains, that if we could tap into our unrealized potential we could learn new languages, solve complex math problems, and bend spoons with our minds. In fact, this notion is the basis for a popular recent movie, “Lucy,” in which the lead character unlocks her hidden mental reserves and does incredible things.

In fact, our best mental performance doesn’t come from doing more with our brains, but from doing less. Most of us have experienced being “in the zone” –whether during an athletic contest or some other period of intense concentration. Time seems to dilate. Five seconds can seem like five hours, and vice-versa. Television and movies depict this state by showing action scenes in super-slow motion. I first saw this on television in the ‘70s. In the series Kung-Fu, David Carradine would seem to hang suspended in mid-air during one of his martial-arts moves.

Brain scientists have studied this state and call it “transient hypo-frontality.” The brain isn’t doing more, it’s doing less. The prefrontal cortex—the part of the brain that houses our sense of will, our sense of self—slows down. Our inner critic is silenced. We enjoy a boosted sense of self-confidence and creativity. This flow-state allows us to focus keenly on the task at hand. Everything else seems to disappear. We’re in what some call “the deep now.” There’s no sense of past or future, and we feel a sense of connection with the everything. But the state is transient—temporary. Eventually, we need to come back to reality, if only to manage everyday life.

Illustration from Gray’s Anatomy (1918). Source: Wikipedia

The market is a lot like our brains: complex, inter-connected, and self-correcting. At any moment, it seems like it’s only tapping into a small portion of its potential. In fact, one or two sectors usually dominate on any given day. That’s the nature of price discovery; the market is always adapting to new information. If you have a disciplined approach to investing, you have to let it work. Silence your inner critic and let the portfolio flow. Otherwise, you’ll end up just chasing the latest trend.

Because following the latest fad means you buy what’s hot and sell what’s not. And that’s a sure way to give your money to the house—again and again and again.

Douglas R. Tengdin, CFA

Chief Investment Officer

Getting Fed Up

Getting Fed Up

What is the Fed?

Photo: Tania Thompson. Source: Shutterstock

For most people, the Federal Reserve is this mysterious place that makes mysterious announcements and that tells the banks where to set interest rates. Academics and politicians may rail at the Fed for various reasons, but their debates often sound like medieval scholastics debating how many angels can dance on the head of a pin: interesting but irrelevant.

The Fed is an essential part of our financial infrastructure—the banker’s bank—that keeps things going when there’s a crisis of confidence. It was created 100 years ago because a modern economy needs a central monetary authority. Banks are subject to crises of confidence. That’s the way finance works.

Calls to “end the Fed”—if they are genuine—are fundamentally misguided. If the Fed hadn’t backstopped the financial system in 2008, most people believe we would have entered another Great Depression. Yes, the Fed is subject to a “knowledge problem,” in that the information it needs to set policy is dispersed among bankers and fund managers and corporate managers and consumers, and that too much aggregation can obscure the data. But this is an issue for tweaking the system, not for fundamentally changing it. Every bureaucratic system faces a knowledge problem.

A modern economy—with trillions of dollars in daily, global money flows—needs a central authority backed by the national treasury. There is no alternative. When a high-profile failure shocks the economy, someone has to be able to step in decisively and restore confidence in the system. Otherwise we will see the “Paradox of Aggregation” in practice—each of us acting in our own rational, private interest creating an irrational, public problem.

Federal Reserve Liabilities. Source: Alephblog

The Fed should be modest in its goals and open about its operations. Shooting for stable prices and a sound banking system is enough for any agency. It shouldn’t try to micro-manage the economy—no one can do that. It needs to be transparent and accountable, because every public institution needs public accountability. We all need to be accountable. But the last thing any central bank should have is a bunch of politicians looking over its shoulder publically criticizing the latest decision.

Because driving down the road with 535 back-seat drivers isn’t just distracting, it’s dangerous.

Douglas R. Tengdin, CFA

Chief Investment Officer

Predator/Prey Model

What’s a shareholder activist?

Photo K Connors. Source: Morguefile

An activist is someone who takes a stake in a company to put public pressure on management to change its approach. Activist goals can be financial, social, or governance-driven. Common objectives might be increasing dividends and share buybacks, reducing excessive management salaries, or disinvestment from particular countries or activities.

25 years ago these folks were called corporate raiders, forcing management to take action or buy them out, often at a fat premium to the current stock price. This sort of “greenmail” seemed deeply unfair. More recently they have been more like investment prospectors, looking for shareholder value in unlikely places—like undervalued real estate that should be sold, or byzantine corporate structures that can be simplified.

Not surprisingly, corporate managers aren’t very fond of activists. Often, activists want management to distribute accumulated cash. That cash can feel like a security blanket—a rainy-day fund in case something goes wrong. But the cash belongs to the owners, not the executives. When it builds up on the balance sheet, management can be tempted to do something stupid—like overpaying for an acquisition, or engaging in high-profile vanity projects.

Activist investors should have a strategic view, and not just focus on short-term returns. Fifteen years ago cash comprised 40% of Ford’s market capitalization. Ford paid out half of this cash-hoard in a special dividend. If they hadn’t distributed this to shareholders, they would have been able to purchase a lot of undervalued assets just a few years later, during the financial crisis. But no one was looking that far forward.

Still, activists can be catalysts, unlocking the value in the underlying securities. That’s why share prices often rise dramatically when their interest is reported. Activist investing can beat passive indices when the activists are effective.

Canadian Lynx. Photo: Rudolfo Usenet. Source: Duke University

These predators just need to be careful that they don’t become the prey!

Douglas R. Tengdin, CFA

Chief Investment Officer

Long in the Tooth

Long in the Tooth

Are FANGs leading the market?

Photo: Gyöngyvér Fábián. Source: Pixabay

Over the past year, the stocks have struggled. Fears about global growth, about China, about a strong dollar, about weak commodity prices have held them back. Year-to-date, the stock market is essentially flat.

But four stocks have stood out: Facebook, Amazon, Netflix, and Google. So far, each of these stocks is up 40% or more; Netflix and Amazon are up over 100%. An equal-weighted portfolio of these FANG stocks, as they are called, is up over 75%. Without these four companies (which actually have five stocks, since Google’s voting and non-voting shares are both in the index), the S&P 500 would be down 2%. What does this mean?

Equal-weighted FANG Portfolio. Source: Bloomberg

These four firms are dynamic, growing companies. Facebook is the dominant player in mobile advertising, with 1.4 billion monthly active users. Amazon’s cloud computing unit has helped them increase their sales, margins, and profits. Netflix is becoming the preeminent subscription video service. And Google has shown that they can control costs. Interestingly, all four firms are growing globally, despite the slowdown in China and problems in other emerging markets. They’re also eating other companies’ sales—like Amazon in retail, or Netflix taking over cable. And the stocks are very expensive.

The average multiple for these four stocks is over 90 times earnings, versus 18x for the S&P 500. Without them, the S&P’s PE would be only 12.5x. Clearly, the market is expecting great things from them. But is this at all realistic? Together, they generate about 200 billion in revenues—growing about 20% per year. That’s impressive, but it may not be enough to justify a 90 PE.

When a few popular stocks mask the market’s general weakness, this can be a dangerous situation. Sometimes, it means that there are hidden currents moving just below the surface. We’ve seen this movie before: young upstarts make good, attract capital, and start to re-make the world in their own image. But if they stumble, watch out. FANGs in your portfolio could bite!

Douglas R. Tengdin, CFA

Chief Investment Officer

Strategy and Tactics

Strategy and Tactics

What’s the difference between investment strategy and investment tactics?

Photo Chil Khakham. Source: Morguefile

Strategic investing is investing for long-term needs. It looks at the world in terms of structures and institutions, and invests in those areas that respect property rights, the rule of law, and that allow capital to flow freely. It understands that small companies, troubled companies, and junior claims on cash flow are more risky, so their returns are more volatile. But if the investor is able to wait long enough—sometimes several decades—that volatility should be associated with higher returns.

Strategic investing works, but only if the investor lets it work.

Tactical investing looks at how things are today and switches readily between companies, sectors, styles, and asset classes. It examines current circumstances and situations as dispassionately as possible to choose which road to follow. Sometimes the well-travelled road is the best choice; sometimes a narrow, rocky path will be better. Tactical investors shouldn’t care. Cash, bonds, real-estate, stocks, commodities—they’re all fair game. The only goal is a bigger payout.

Tactical investing also works, but only if the investor makes it work.

Both approaches have their strengths and weaknesses. Tactical investing tends to be expensive. Strategic investors need to be patient. Tactical investing requires volatile activity. Strategic investing focuses on volatile markets.

Whether an investor focusses on tactics or strategy is both a matter of temperment and resources. An investor who wants to be strategic but doesn’t have the time or perseverance to wait through the dark periods shouldn’t choose that route. Conversely, an investor who wants to minimize costs—research, transactions, fees—shouldn’t try to be tactical.

Your investment approach needs to fit your attitude and aptitude like a hand in a glove. And a glove that doesn’t fit is often worse than no glove at all.

Douglas R. Tengdin, CFA

Chief Investment Officer

Hacking, Crime, and Fraud

What does the latest hacking prosecution say about online security?

Photo: Victor Hanacek. Source: Picjumbo

The US Attorney for New York just disclosed the biggest hacking prosecution ever. In a news conference, Breet Bharara described it as securities fraud on cyber-steroids. A gang of criminal hackers from the US, Russia, and Israel broke into Scottrade, Dow Jones, and JP Morgan. They obtained the personal data and email addresses of over 100 million people. But rather than steal money directly, they used this information to solicit business for online casinos, bogus drugs, and pump-and-dump stock schemes.

They then took over a bank and a bitcoin exchange to launder their ill-gotten gains—to make them look legitimate, and to be able to use their hundreds of millions in other criminal enterprises. They also hacked into fraud-prevention companies to keep their operations from being flagged. But at the heart of the biggest cyber-crime enterprise ever were spam emails and solicitations to buy pick-sheet penny-stock shares.

This is actually encouraging. Our interconnected world puts a lot of financial data out in the cloud. But when the most sophisticated cyber-mafia in the world hacked into these networks, they still couldn’t rip people off without their help. If you didn’t play online poker or buy off-price Lipitor, or buy stock in a mining company no one’s ever heard of that claims to have billions in gold in Borneo, you probably weren’t a victim. Technology only took these criminal masterminds so far.

Most of our online security is working. These crooks monetized their stolen information via human greed and stupidity, manipulating people rather than manipulating databases. I’m happy the hackers were caught. But I’m even happier that their new-fangled crimes were so old fashioned.

Douglas R. Tengdin, CFA

Chief Investment Officer

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