Limits

Everyone’s telling our new president to spend, spend, spend. They may well be right. But there are limits.

Eighty years ago Keynes noted that additional government spending, funded by debt, can change the economy’s direction. But that assumes people don’t know or care where the money comes from. That is, if the government borrows from the future to spend more today, Keynes assumes that people won’t adapt their behavior

But the beauty and curse of our society is that we do know where the money is coming from: we’re borrowing it from future growth. Interest on these loans needs to be paid, and the loans will need to be renewed as they come due. If we borrow a modest amount to get through a rough patch, people probably will spend the proceeds. But if the government borrows massively, I suspect that the expectation of higher future taxes will frustrate Washington’s best laid plans.

The New England moral is, if you lend your teenager money to buy gas, spot a twenty—don’t hand over the credit card. Because you may not be able to afford that bill.

Douglas R. Tengdin, CFA
Chief Investment Officer
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One

“In a crisis, all correlations approach one.”

This is the counter-argument to my note about diversification yesterday. In other words, there are limits to how much you can reduce your risk. To use an agricultural metaphor, planting corn, beans, and squash may limit your losses if corn-borers proliferate, but it doesn’t help much when a swarm of locusts appears.

That’s what we’ve witnessed over the past year. The best performing stock markets, globally, are still down around 40%. Bonds usually hedge stocks, but the only positive returns there have been US Treasury bonds. Most other bond markets have gotten killed.

General bear markets, like locust infestations, are rare, but they serve a purpose. When the land is cleared, plants with the strongest roots come back quickly. By clearing out weak and imprudently managed companies, the markets’ decline strengthens the economy’s long-run potential. In this case the global economy is being refined. That which does not kill us should make us stronger.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Classical Investing (Part 1)

The classics are often filled with sound advice for investors. And no wonder. Good investment guidelines are usually common sense tripped out in financial language. But since the best of the classics address timeless truths of human nature, it’s no surprise that they contain sage exhortations that have stood the test of time.

As an example, the biblical book of Ecclesiastes says: “Give portions to seven, yes to eight, for you do not know what disaster may come upon the land.” Here is a truth that Harry Markowitz restated in the ’50s to win the Nobel Prize: diversification reduces risk. Of course, he quantified the degree of risk reduction and identified the optimal level of diversification. But the basic principle is still the same.

Over the years, some have held out diversification as a way to enhance returns. After all, you don’t know what latent good news is out there, either. And in good times this seems to work. But often the way to win is not to lose. And the best way not to lose, is to diversify your investments: assets, sectors, and holdings.

Douglas R. Tengdin, CFA
Chief Investment Officer
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You Get What You Pay For

Twenty-nine years ago Tim Geithner had just arrived on the Dartmouth College campus. The prospective Treasury Secretary was a studious, quiet student, who did quite well as an Asian Studies major.

After some time with the Foreign Service and Kissinger Associates, he distinguished himself at Treasury during the Asian Contagion with his understanding of East Asia markets and their cultures. His success in that crisis propelled him to the leadership of the New York Fed, and now to the Treasury Secretary’s office

This seems a particularly appropriate time for Mr. Geithner to take the helm at Treasury. The two most important actors on the world stage right now are the American Consumer and Chinese lenders. Both need each other. Without American demand, China will have to shut down its factories. And without Chinese credit, consumers won’t be able to finance what they buy.

Mr. Geithner comes to Treasury when an honest broker with cross-cultural understanding is needed more than ever. Here’s hoping that the quiet, likeable official can help calm the markets. That’s some change I could believe it.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Getting What We Pay For

Everyone wonders why we got into this mess. One place to look is tax policy.

Back in the ‘80s, we lowered the tax rate and eliminated a lot of deductions. But a few stayed. Specifically, mortgage interest is deductible for consumers but corporate dividends are not deductible for companies. Since that time, mortgage debt has exploded and corporate equity has contracted a percent of our economy.

This isn’t an issue of national irresponsibility. This is a matter of getting what we pay for. Washington has decided to subsidize home ownership and to penalize corporate dividends. Is it any wonder that we have an surplus of mortgage debt and a dearth of corporate equity in this country? Now we’re seeing some of the unintended consequences.

The national scolds all say that we’re headed for a time of national retrenchment, with consumers increasing their savings because they’re “supposed to.” But I don’t see it unless and until Washington stops subsidizing debt and penalizing savings. Because, when it comes to our money, taxes speak louder than words.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Whitewater (Part 5)

When markets get scary and volatility gets crazy, you need to adapt your attitude.

An ancient Chinese curse goes something like, “may you live in interesting times.” Well we’ve been living through interesting markets. But they don’t have to be a curse if we have the right mind-set.

And that’s rule #5 for whitewater investing: enjoy the ride. We have to change our approach to the market if we want to profit from today’s turmoil. Some compare a bear market to a sale at an investment store. We can buy the same, name-brand merchandise for half the price we used to pay. And in many cases, those companies are just as profitable, if not more so now, than they were before the downturn. If we get energized by a sale at our favorite retailer, why not get excited about finding Wal-Mart in the bargain bin?

The ups and downs of the market don’t need to be frightening if we see them the right way. If we view investing as a journey and we learn to enjoy the ride, getting there can be half the fun.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Whitewater (Part 4)

Whitewater rules are different than flat-water rules. And if you want to survive and even thrive when things get rough, you need to adapt to the new conditions.

Rule number four is to be flexible. Your strategy may not need to change, but your tactics probably do. Rapidly changing investment conditions may make some securities extremely cheap or expensive. You may need to adjust your thinking to take advantage of them.

An example right now would be TIPs, inflation-protected bonds issued by the Treasury. Right now the expectations for future inflation are so low that TIPs are very cheap. In fact, in order to justify holding regular Treasury bonds versus TIPs, you’d have to expect inflation to average less than 1% for the next 10 years. With the Federal government printing so much money to get us out of the financial crisis, it’s a pretty good bet inflation won’t stay that low for very long.

Roiling markets can splash up some real bargains now and again. When the market changes, you should, too.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Whitewater (Part 3)

We’re in a period of extreme volatility right now—what I call “whitewater investing.” And whitewater investing calls for whitewater rules.

Rule number three is to work with a team. Calm markets and calm water allow you to work by yourself. But when the water starts to roar you need to have a team you can trust, especially if anything goes wrong. For example, taxes aren’t much of an issue if you can invest and hold on for decades. But when you need to make adjustments in volatile times, tax-planning is critical.

Likewise, custody was an unimportant detail until a little firm named Lehman seized up. Then investors that had accounts with Lehman couldn’t get to their money for weeks. And investors that didn’t pay attention to fine print that allowed advisers to substitute “cash-equivalent” Auction Rate securities got a rude awakening when they couldn’t use their cash. Knowing how the brokers were paid might have helped those investors understand why they owned those bonds.

Teammates matter. Details matter. Motivation matters. Having a team that you can depend upon is critical as you move through turbulent markets.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Whitewater (Part 2)

There’s rules for running the rapids. Follow them and you can prosper and even have fun. Ignore them and you’ll end up in the soup.

Rule number two is don’t avoid trouble—plan for it. Kayakers don’t try to avoid going over. They roll with the current and come up on the other side. And they always, always wear a life vest. That way if the worst happens, you can still float.

The investment analogy is to plan for investment errors. Nobody gets it right every time. There are too many variables: management issues, balance sheet surprises, changes in conditions, etc. The key is to have a plan to roll with the issues. Sometimes surprising weakness is a signal to buy more—sometimes it’s a sign to get out. The key is being ready to act when you need to.

And the life-vest is your safety net. Always have a safety net—enough assets in safe, liquid investments to get you through the most difficult conditions for a minimal time.

Financial markets will send problems your way. By preparing for trouble, you can be confident that the rapids’ rough going won’t sink you.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Whitewater (Part 1)

Where I grew up in Minnesota, when we went canoeing the river was usually flat and peaceful. We’d reach our destination, but it was mostly paddle power and a smooth current.

Occasionally the river would get a little rough, and we’d encounter some rapids. Now normal people usually avoid the whitewater. But if you develop certain skills, you can read the rapids, avoid the rocks, and even thrive.

It’s like that in the market right now. We’re in a period of rapid, roiling change. And there are some rules that you have to follow in the rapids, or you’ll get in trouble. For example, always stay with your boat. Investment-wise, stick to your plan. Panic-selling is a recipe for disaster. Most investment plans are designed around things like your age, income, and goals. Those things don’t change with the level of the stock market.

The markets are churning right now. But if we read the rapids right, we’ll come out of this. We might even have some fun.

Douglas R. Tengdin, CFA
Chief Investment Officer
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