Great Expectations

Is the market suffering from a case of mistaken identity?

Public Domain. Scene from “Great Expectations.” Source: Wikipedia

In Charles Dickens’ novel “Great Expectations,” his main character Pip is a poor orphan who suddenly starts to receive money from an unknown source. He thinks his mysterious benefactor is the cold and eccentric Miss Havisham. Miss Havisham is wealthy but mysterious, and she had taken Pip on as a companion for herself and her adopted daughter, Estella.

In reality, though, Pip’s money was coming from a formerly escaped convict, Magwich. Pip brought Magwich some food and a file after the convict scared Pip into helping him. Even though Magwich was recaptured and sent off to Australia, he remembers Pip’s kindness and starts to support him after Magwich gains his freedom in New South Wales.

Today, the market is hyper-focused on our global central banks—obsessing whether Janet Yellen’s Fed will raise rates ever-so-slightly in December, or put off the decision to a later date. Like Miss Havisham, the Fed is mysterious and full of strange omens. And our economy keeps moving forward, in spite of the many problems we’re facing.

In fact, however, the economy’s real support is coming from China. China’s economy has grown by almost $5 trillion over the past five years, while the US, Europe, the UK, and Japan combined haven’t expanded by even $1 trillion. All the machinations of our various central banks haven’t been able to overcome the problems posed by the hangover from the financial crisis, the Euro, terrorism, and other issues. Although China faces some serious difficulties, they are the complications that come from growth—from over 300 million peasants moving from the countryside into an urban, industrial economy. Frankly, these are problems the rest of the world would like to have.

Source: World Bank

Towards the end of Dickens’ novel, Miss Havisham eventually tells Pip that all her actions were designed to make him miserable—shortly before she accidentally sets fire to her dress. Let’s hope we never find our central bankers with their hair on fire.

Douglas R. Tengdin, CFA

Chief Investment Officer

Dreamers and Doers

Why do people start new companies?

“Wisteria” by Claude Monet. Source:

At the heart of capitalism is the start-up—a new project founded on an idea and some hustle that creates a business out of nothing. If the idea catches on, the founders can make a lot of money. If it flops, the founders learn what doesn’t work and move on.

Many folks fail in their first attempts. It’s a costly tuition. That’s because there are so many ways for things to go wrong: growing too fast, moving too slow, hiring the wrong people, being over-controlling. It’s like science: knowledge grows by proving what doesn’t work through experimentation. But experimenting with your life can be a volatile experience.

Most startups are founded by technicians—engineers, design professionals, real-estate developers—who may understand how to make a product, but who don’t necessarily know how to run a business. They pick up the business skills along the way—or not. Sometimes, the idea is so good that it succeeds in spite of their mistakes. But entrepreneurs don’t usually upend their lives for the money: they do it for the adventure, they have a vision, or because it gives them a sense of control over their own future—instead of wilting inside a bureaucratic structure.

Start-ups struggle to succeed because new ideas often do not scale well—you can’t just add more people to make something big. There may be a payout at the end; more often there isn’t. But a startup allows its founders to dream. And the founders believe, as some have said, that if you can dream it, you can do it.

Douglas R. Tengdin, CFA

Chief Investment Officer

Right Track / Wrong Track / Off Track

What makes some companies thrive while others struggle?

Photo: Lexcelsior. Source: Animal Photos

We see lots of examples in the marketplace: Facebook created the dominant digital social network, while other platforms—MySpace, Friendster—never took off. Costco has grown as a discount club while Wal-Mart struggled. Johnson & Johnson has succeeded across a range of health-care businesses, while others faltered—brought down by scandals or shrinking markets. What’s the difference?

It comes down to management. Successful companies need visionary leadership—leaders that create a sense of community where their people have a chance to grow and develop, to try out new ways of doing things, where workers know that someone takes a genuine interest in them—not only as workers, but as people, too.

The military has a phrase for this: “officers eat last.” The higher ranking you are, the further back in the chow line you’re supposed to stand. The brass may represent the brains, but the enlisted folks are the brawn. Without enlisted men and women, there’s no need for officers. The attitude of those on the front lines is critical to any mission’s success. And morale can’t be commanded. It has to be nurtured.

Photo: Mary Vogt. Source: Morguefile

But leadership isn’t enough. To succeed on the battlefield, a unit can’t just believe and trust in its commanders. It also has to be going in the right direction. Having the right strategy is critical. Steve Ballmer was seen as a visionary leader at Microsoft. But they missed to boat on mobile applications and devices. Their software become over-engineered with “feature-creep” that made it confusing and difficult to use. And they focused on their desktop platform for too long. During his tenure at the helm, Microsoft became a wealth-destroyer.

Leaders inspire their people to outperform because they present a vision that’s bigger than themselves. But they need to be going the right way. Proctor & Gamble had a vision for where they wanted to go when they acquired Gillette. They paid a very high price, and the market was skeptical that the acquisition would be successful. But P&G used its expertise to create an ecosystem of shaving products around the already-dominant shaving brand, and the merger created value for everyone: consumers, employees, and shareholders.

Source: Bloomberg

An important investment theme is quality. When investors look for quality companies, they need to look beyond the bottom line: return on assets, cash-flow management, financial structure. Those metrics are important, but they’re not enough. We need to look at people across the firm to see if they’re inspired—and inspiring others—to move in the right direction.

Douglas R. Tengdin, CFA

Chief Investment Officer


Why is the economy growing so slowly?

Source: St. Louis Fed

Since the Great Recession, the economy has never gotten back into high gear. We’ve always seemed to be teetering on the edge of another downturn. Quarterly economic growth has averaged 2%, while a normal recovery is usually above 3.5%. Why?

First, the workforce is changing. We are now entering the period where baby-boomers are beginning to retire. Like most things the boomers have gotten involved with, they are transforming retirement. Their family finances may be stretched by having debt from putting kids through college, or because one in four have adult children living with them. Also, the changing nature of health care is changing everyone’s work patterns.

Second, there are some special factors that have made this recovery more difficult. Because the boom was in housing—creating oversupply—lower interest rates have not been able to stimulate the homebuilding sector very much. The Euro crisis and China’s economic restructuring have put a serious dent in demand for US exports. Long-term financial challenges in the States have reduced government hiring.

GDP Composition. Source: FRB Richmond

Finally, there are some long-term trends in productivity that began about 10 years ago. Growth in technology has been centered around software—an informational product—which doesn’t get consumed when someone uses it. My web-search doesn’t prevent you from searching the web. There’s also evidence that much of our newest economic activity isn’t being measured. For example, more pictures are being taken than ever before. But the GDP contribution from photography has actually plummeted over the last decade, as many people use smart-phones to take, upload, and share photos. This is a way that the measured economy is depressed by new technology.

There’s no magic here. Our slow-growth economy hasn’t developed because rates are too low or the Chinese are stealing our jobs or unicorns in Silicon Valley are too greedy. If we want to get the economy moving again, we need to encourage what creates economic growth in the first place: innovation, ingenuity, and productive people.

Douglas R. Tengdin, CFA

Chief Investment Officer

A Brief History of Bubbles

What’s wrong with bubbles?

Photo: Michelle DiNocola. Source: Morguefile

Sir John Templeton once famously noted that the four most expensive words in the English language are, “This time it’s different.” It’s easy to get caught up in the excitement of the moment, to believe that the latest innovation will lead to a new era. But human nature doesn’t change. That’s why it’s so fascinating.

Before the first documented financial bubble—the tulip crisis in 17th century Holland—there were other markets that were manipulated and distorted. In ancient Rome, currencies, bonds, and investments changed hands in the Forum, with little regulation or security. When the emperor ran short of cash—often due to war—he would debase the currency, adding base metal to the coinage. This led to inflation, currency speculation, and economic chaos.

Speculation in Rome was followed by speculation in Holland (tulips), speculation in France (The Mississippi Company), speculation in London (The South Sea bubble, which captured Sir Isaac Newton), speculation in Brazil (Encilhamento), and speculation in New York. They all follow the same pattern: a genuinely new development takes place; prices begin to adjust, investors notice the price movement and jump on board, eventually using leverage to increase their holdings; prices become increasingly divorced from reality; finally, the bubble bursts and prices revert—suddenly—towards a more economically rational level, given current financial conditions.

Photo: Koan. Source: Morguefile

Bubbles cause economic harm in two ways: during the boom they waste resources on over-building that could have been employed productively; and the bust can cause financial retrenchment when borrowers default on underwater asset-based loans. This can lead to a systemic loss of capital in the banking sector causing banks to pull back on lending. When loans contract across an economy, a burst bubble can lead to a recession—or even a depression.

Do we have any sectors of the economy that look like bubbles now? I haven’t noticed any. But one feature of bubbles is that they’re hard to see. We fool ourselves into thinking that a new era has arrived, or is about to: a “new normal.” Hmm, maybe we’re in danger bubble-thinking after all.

Douglas R. Tengdin, CFA

Chief Investment Officer

Apples, Banks, and Money Management

Can the market for apples teach us about money management?

Photo: Arly Flo. Source: Wikimedia

Like many people, I grew up with the saying, “An apple a day keeps the doctor away.” Apples are supposed to have all kinds of health benefits—from helping your digestion to reducing cholesterol to improving your memory. And—unlike a lot of healthy foods—they taste pretty good. But I was never really keen on apples. You see, when I was young, pretty much every apple looked and tasted the same. It was a bright, somewhat mealy variety called “Red Delicious.” And they weren’t very delicious.

When I had an apple in my school lunch, I would eat it. But I didn’t enjoy it. The flavor was—um—okay, but nothing to write home about. Apples may have been good for you, but that’s about all they were. And if you went to the store, there wasn’t much choice. There was either Red Delicious, Golden Delicious, or green Granny Smith.

This wasn’t good for consumers, and it wasn’t good for producers, either. Apples were a commodity. One apple was pretty much identical to another. And like all commodities, only the lowest-cost producer makes any money. Any commodity business is brutal. Smaller apple orchards around the country were shutting down. Production was shifting to mega-farms in Washington State, which used mass-farming techniques to become more efficient. In the mid-‘80s, there was a health scare involving Alar, a chemical sprayed on apples to regulate their growth. It seemed like everyone was losing out: producers were going out of business, and consumers got generic, mealy apples grown with toxic chemicals.

Source: Canada Department of Agriculture.

Around that same time, some scientists at the University of Minnesota discovered a better apple—one that really stood out. They called it Honeycrisp, and some farmers started raising them. Hey, they thought: if I’m going to go out of business, I might as well do it raising something tasty.

And consumers loved them. Honeycrisp apples could sell for twice the price of generic Red Delicious. The farmers were able to survive, and even expand. Soon, new breeds were discovered. Now, when you walk into a store, you see dozens of varieties: Gala, Jazz, Winesap, Macoun, Braeburn. Everyone has a favorite. Some times of the year, apples are the top selling item in the store—more than chicken or milk or cereal.

There’s a lesson here. When a market is dominated by a commodity-type product, only low-cost producers can thrive. But pressures mount to ramp up production to take advantage of economies of scale. After all, someone else might sell their goods for just a little less. Amid that pressure, corners will be cut. In this light, it’s no surprise that the largest retail bank in the country had an ethics scandal involving generic banking products. Money is a commodity.

The same pressures are mounting in the money-management industry. Generic index funds are growing and growing and growing. Over half of the publically traded stocks in the US are held by five giant mutual fund families. And they’re efficient. You can now own $100,000 portfolio of blue-chip equities and pay $40 / year in fees. It’s likely we will soon see “free” products created and marketed, the same way consumers can get free brokerage and free checking. Who knows? Maybe some aggressive fund companies will adopt negative management fees—like negative interest rates—making money on the order flow.

But you get what you pay for. Generic products lead to generic performance—the equivalent of Red Delicious portfolio products. And mass-produced goods always come with issues, whether you can see them (yet) or not. People and institutions need customized financial guidance. Everyone is unique—with their own assets, liabilities, income, and tolerance for risk.

The solution for money managers isn’t to become cheaper, it’s to provide a tastier solution. Smaller producers can survive, and everyone can be better off. But only if they embrace innovation.

Douglas R. Tengdin, CFA

Chief Investment Officer

Insiders and Outsiders

Insiders and Outsiders

What’s wrong with insider trading?

Photo: Massimo Mancini. Source: Unsplash

Insider trading strikes most of us as deeply unfair. If a banker passes along a tip about an upcoming deal to his cousin, and the cousin uses the information to make a bundle, we know in our guts that this is wrong. But who’s the victim? If the banker didn’t receive any compensation for leaking the information, where’s the crime?

Some legal scholars have questioned what’s wrong with insider trading in the first place. It seems like a victimless crime. It may be unfair that the someone profits because they have a well-placed relative, but lots of things in life are unfair. More information is supposed to make market prices more efficient and accurate. And market prices are used to determine lots of things, from credit-worthiness to the fair value of new firms coming to the market.

Insider trading damages the integrity of the marketplace. If outsiders believe they have less accurate information than insiders, they won’t invest. This lowers aggregate prices and increases volatility, raising the cost of capital for firms overall. Also, there’s some evidence that insider trading laws encourage innovation. In a study last year, three researchers looked at countries that started to implement strict insider trading regulations. They found a sharp increase in patent applications once insider trading laws began to be enforced.

Our insider trading laws are a mess in part because they’re based on a clause of a 70-year old law that’s been gradually refined by case law—and by some overly zealous prosecutors. Congress could clean this up and make it clear what is and is not material nonpublic information. That might make things more efficient—and more fair.

Douglas R. Tengdin, CFA

Chief Investment Officer

Cost, Price, and Value

“A cynic knows the price of everything and the value of nothing.” Lady Windemere’s Fan, Oscar Wilde

Photo: Napoleon Sarony, 1882. Source: Metropolitan Museum of Art

Full disclosure: I am a financial professional who manages money. So my comments are slanted. After all, where you stand often depends on where you sit. And I sit where I can manage individual and institutional portfolios, using—mostly—individual stocks and bonds. I avoid using mutual funds because of the conflicts that are inherent in their business model.

What conflicts? Mutual funds provide an efficient way for an investor to own a stake in a portfolio of securities. They can own a broad index like the S&P 500 or the Barclays Aggregate Bond Index, or they can have a fund manager actively choose which securities to own. They’re typically managed by a fund company, which charges an annual fee based on the assets in the fund. Index funds are typically cheaper, since they’re not paying a manager to pick stocks or bonds. There’s a lot of emphasis these days on using cheap index funds to manage your money.

But not all indices are created equal. Some indices are “open,” meaning that everyone knows what will go in and what comes out on specified rebalancing days, while others are “closed.” Some indices charge more for their analytical information than others—what weights they use for different securities, what categories they classify them into, and so on. So mutual funds have an incentive to use cheaper indices as their benchmarks—even if their open structure leaves them vulnerable to arbitrage.

Here’s the way it works: An open fund has a simple rule to determine who is in and who is out of the fund, and a date set when they will rebalances. Arbitrageurs buy or sell securities before that date, knowing that anyone who strictly follows the index will only buy or sell when the index does. By doing this, the arbs can scalp as much as 2-4% from the index’s performance.

Consistent underperformance of an “open” index. Source: Bloomberg

But the index fund’s investors have no idea that this is going on. They just see that their fund has performance that tracks the index. And they see a low management fee. So the mutual fund wins—they get to market themselves as “low cost”—and the arbs win, by scalping performance. But the mutual fund’s investors lose—without ever knowing it. And there’s no requirement to disclose a fund’s performance against a different index.

Remember those mileage stickers that car companies put on the windows of new cars? They always come with a caveat: your mileage may vary. Cost may be a place to start when evaluating an investment, but it’s never where you should stop. Fees matter. But they only indicate a fund’s price. Not its value.

Douglas R. Tengdin, CFA

Chief Investment Officer

More or Less

What’s a mini-IPO?

Photo: Dan Morgan. Source: Wikipedia

A mini-IPO is a limited stock offering that doesn’t have to jump over all the regulatory barriers of a regular IPO. The new rule is known as Reg A+, and it’s part of the JOBS act—a measure designed to make it easier for companies to raise capital.

When the rules took effect in June, almost 100 firms signed up right away. But so far, only a handful have actually sold any stock under the bill. It turns out that getting investors in a start-up isn’t as easy as it seems. Companies can offer their shares, but that doesn’t mean anyone has to buy them. Just because the SEC has eased some of the registration rules doesn’t mean investors have relaxed the rules of due diligence.

Elio Motors, a mini-startup. Source: Bloomberg

For example, start-ups can sell up to $20 million in company stock without providing audited financials. But most investors still want them. And for good reason: the financials provide the clearest picture of how a concept is actually working out. Without auditors to prove those numbers back to actual bank balances, the temptation to fudge the numbers could be overwhelming. I certainly won’t commit capital to an enterprise when I can’t have an independent party check it out.

Miniature horses were bred to do a big horse’s job in a small space—like hauling rail cars in coal mines. A mini-IPO should work the same way—allowing public registration in a limited context. But it doesn’t work that way. Part of what makes an IPO work is the buzz that comes when lots of investors are excited. With mini-IPOs so limited in scope, that buzz never builds.

Pit ponies stabled in a mine. Illustrator: Albert Sidney Bolles. Source: Wikipedia

The markets aren’t a giant piggy-bank with investors dying to put their cash into new, untried concepts. Lots of people can tell a good story. But it takes a lot of work to turn a story into a profitable enterprise. New SEC regulations don’t change that.

Douglas R. Tengdin, CFA

Chief Investment Officer

Flash Futures

Are flash-crashes the future?

Photo: Ostephy. Source: Morguefile

We’ve seen flash-crashes in stocks and in bonds. It’s inevitable that they should spread to other asset classes.

Early this morning the British Pound fell by over 6% in a few minutes. The exact magnitude of the fall is unclear, because the currency snapped back so quickly. One pricing service had it as low as 1.13 to the dollar, after opening the day around 1.26. It quickly came back to 1.23, a modest 2% drop. Over the past year, though, the Pound is down 20%.

British Pound vs. US Dollar, 10-6-16 through 10-7-16. Source: Bloomberg

Nothing really justifies a drop of this magnitude. There has been some talk of Europeans taking a hard line against the UK in Brexit negotiations, but nothing to justify this level of volatility. In the past several years “flash crashes” have become more common, often linked to Exchange Traded Funds and algorithmic trading. This is the first one that has involved the currency markets.

It’s unnerving when one of the world’s major currencies can move so dramatically. Over $6 trillion trades daily in the global currency market, facilitating trade, investments, capital flows, and other economic purposes. That’s a significant proportion of the global economy. This is a deep and liquid market. By contrast, stock trading on all US exchanges totals about $270 billion per day.

Photo: Katrina Tuliao. Source: Trader Group

This is possibly a result of robo-traders entering the foreign exchange markets as large financial institutions withdraw from currency dealing. Partly as a result of the Basel III capital rules and partly because of the forex price-rigging scandal, big banks like Citi and Barclays aren’t as active as they used to be. As they’ve pulled back, new trading firms have moved in—Citadel Securities, Global Trading, and Jump Trading, among others. These algorithmic market-makers aren’t supporting correspondent banking services or large corporate clients. They can pull out of a market as quickly as they enter. And as we’ve seen recently, this can exacerbate the trends and lead to breathtaking volatility.

This is not your father’s forex market. Cable and Swissy swaps aren’t limited by the speed of a trader’s fingers or the breadth of their trading blotter. It’s a brave, new world, that hath such algos in it.

Douglas R. Tengdin, CFA

Chief Investment Officer

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