Remember Indiana Jones and the Last Crusade?

When Indiana gets to the cave where the Grail is kept, he’s confronted with an array of choices. One brings life, the others are fatal. His only aid is his understanding of history and a little common sense. He did okay. His rival didn’t fare so well.

That’s my theme for 2010: choose wisely. Confronted by volatile markets? Choose wisely. Finding unforeseen risks? Choose wisely. Facing various political or personal choices? Choose wisely.

Our sources of wisdom can be varied: from detailed quantitative number-crunching to reflection on our own evolving circumstances and needs; from understanding the insights of the classic texts of Civilization to applying the methods and models available via Bloomberg and Graham and Dodd.

What’s necessary as the economy develops and the markets gyrate is wisdom that comes from self-understanding and detailed analytical knowledge. In 2010 the variety of choices we face will expand. It will be necessary for all of us to increase our wisdom.

Indiana’s rival was undone in the cave because his ambition got the better of him. But a little common sense and knowing the context will yield wisdom in the end.

Douglas R. Tengdin, CFA
Chief Investment Officer
Hit reply if you have any questions—I read them all!

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The monetary base is exploding. So what?

Traditionally, when the base grows, the monetary aggregates grow thereafter. Since inflation is a monetary phenomenon, the concern is that the cash will find a home in consumer goods, and inflation will rise. Is this realistic?

Well no and yes. No, because the monetary base is really an artifact of the bank bailout, the Fed’s liquidity programs, and the interest that the Fed now pays on reserve balances. A year ago interbank lending dried up on credit fears, so the Regional Federal Reserve banks became clearinghouses for overnight loans. Our statistics don’t adjust for this, so it looks like monetary growth is booming. But when you make the adjustments, it really isn’t.

So money growth won’t spark inflation anytime soon. But what about further out? The concern there is politics. As the economy recovers, interest rates will need to rise. Since the Fed is more political now, they may get behind the curve and allow inflation to accelerate. After all, it was former Labor Secretary and politician Robert Reich who quipped, “A little inflation never hurt anyone.” Talk like that makes you want to buy TIPs and gold.

Which may be happening. Those assets recently traded at new highs, and expected inflation is creeping up. But it’s not money that worries us. It’s politics.

Douglas R. Tengdin, CFA
Chief Investment Officer
Hit reply if you have any questions—I read them all!

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Bull markets are usually built on three legs. How far have we come?

The three legs of a bull market are valuation, growth, and retail purchases. They usually emerge in that order.

Valuation comes when everyone thinks the world is ending. We had that last winter. At it’s bottom, the market was selling at an “earnings yield” of 10%. That is, for every $100 you put into the market, you could expect $10 in earnings. That was when Treasury Notes yielded less than 3%. Now the market yields 5 1/2% while Treasuries yield about 4%. The value is there, it’s just less compelling.

Growth is the next leg. The economy has started to grow, so earnings will grow as well. Maybe not as fast as some expect or hope, but growth has unquestionably begun. The stock market anticipates the economy, usually by 6 months or so. Since economic growth has begun so can the stock market.

The final leg is retail participation. Up to this point, the stock market rally has been surprisingly devoid of mutual fund inflows. But that seems to have changed. During the week that ended on Christmas equity mutual funds received over 11 billion dollars, the highest weekly flow in a year and a half. While flows for the full year are down over $60 billion, it looks like this indicator is turning around.

With all three legs in place, it looks like the market can continue to grow. But don’t get complacent. When everyone is finally on board, the trip may be most of the way over.

Douglas R. Tengdin, CFA
Chief Investment Officer
Hit reply if you have any questions—I read them all!

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“When sorrows come, they come not single spies but in battalions.”

When Shakespeare wrote this he was reflecting how life seems to deal out trouble. Tiger Woods is the most recent observer of this. First it was a car accident. Then it was a marital fight. Then one, two and more of Tiger’s illicit madams spoke out in public. And the press just lapped it up.

Woods’ response was a classic case of how not to handle a media mauling. The information was sparing, contradictory, and sporadic. His latest statement about being left in private is both self-serving and contradictory. He has (or had) millions of fans.

Jack Welch—who has dealt with his own crises multiple times—has some good advice: First, tell the whole truth. People are remarkably forgiving when they’ve been leveled with. Second, be consistent. Inconsistency breeds mistrust. Finally, take responsibility for your media coverage. In these days of web-pages, Facebook friends, and Twitter-feeds, there is no excuse for waiting for the media to call you.

Amazingly, Tiger’s web page has almost no mention of his troubles. Tiger’s not a victim, and his fans deserve better. The troubles that face us often come in battalions, because we ask for more recruits to join the party.

Douglas R. Tengdin, CFA
Chief Investment Officer
Hit reply if you have any questions—I read them all!

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Is moral hazard at the root of our financial troubles?

Many look at our recent financial crisis and say that the heart of the problem is moral hazard. That’s the problem you get when speculators get to keep the upside if things work out, but they offload any losses to the government.

Deposit insurance is a typical example. Small depositors have no incentive to check on their bank’s solvency, because the Feds will step in if there’s a problem. Supposedly, this incents bankers to go wild, because they get to keep the upside but the FDIC is stuck with any problems.

Only, not. For one thing, bankers who blow up a bank are out looking for a new job. And having a failed institution on your resume isn’t exactly a career builder. Also, having your bank taken over or forcibly merged isn’t exactly a walk in the park for depositors. Temporary hassles always appear, deposit rates can be re-written, and other stuff happens.

And there’s no evidence that things are worse now with deposit insurance. During the ‘20s and before we had financial crises, and supposedly there was no moral hazard because there was no FDIC. To me the moral hazard argument is too convenient: conservatives get to blame the government and liberals get to blame the banks.

It’s been said that when everyone thinks alike, somebody isn’t thinking. Let’s hope more clear thinking about moral hazard and the banks prevails.

Douglas R. Tengdin, CFA
Chief Investment Officer
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It’s been said that when countries become too indebted, they either default or inflate their way out of the problem.

This is a real issue. The Federal Government ran a deficit equal to 10% of GDP last year. That’s the largest budget gap in the developed world. Only two years ago it was about 2% of the economy. For the past 40 years, the fiscal deficit has averaged about 2 ½ percent. And lest one is tempted to be partisan about this, let it be noted that Nixon, Ford, and Clinton all saw surpluses.

But now that we’ve borrowed the money, what can we do? Default just isn’t an option in a fiat currency. But inflation? This ignores history. Double-digit inflation wasn’t brought on by deficits: the ‘70s deficits were moderate. And when you can buy TIPs, inflation isn’t a risk at all.

One option rarely mentioned is just growing up. The debt incurred in the ‘80s became less and less important in the ’90s and the ‘00s as the economy grew. That wasn’t inflation, it was just solid economic growth. 200 billion dollar deficits, an item of panic under Reagan, now seem quaint.

Parents often hope their kids will grow out of bad behavior. Hopefully the same thing will apply to our economy.

Douglas R. Tengdin, CFA
Chief Investment Officer
Hit reply if you have any questions—I read them all!

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Of all the questions a portfolio manager can ask, one of the most important is this: how much risk can you handle?

Risk is usually defined as variance in prices. This is convenient, because it allows us to quantify it. Long-term bonds are more risky that short-term; junk bonds are more risky than investment-grade; stocks are more risky than junk bonds—because their prices move around more.

But this misstates the issue. Lots of investors don’t worry about daily or monthly price changes. They want a stable income stream and a gradually growing level of capital. For these—and perhaps most—investors, anything that might threaten income or capital in the long run is meaningful. The problem we face is that many possible scenarios may unfold: more things can happen than will happen.

Diversification is an admission of our ignorance of the future. Another is making sure our decisions are reversible. How hard is it to back out of a mistake? Liquid investments like stocks and bonds make it quite easy. Others, such as annuities or hedge funds, can make it quite costly.

The past is not prelude, and history is not destiny. The sources of uncertainty today are manifold, and the keys to handling them are diversification, control, and transparency. We simply don’t know what the future holds. Anyone who tries to claim otherwise is selling something.

Douglas R. Tengdin, CFA
Chief Investment Officer
Hit reply if you have any questions—I read them all!

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We’ll they’ve come down from the mountain. The Fed completed its two-day meeting this week, and they didn’t change policy. Yawn.

The economy is weak, but it’s showing signs of life. So the Fed plans to let its extraordinary support expire on schedule. How remarkable! When the Fed planned to support the commercial banks or the money market funds or the mortgage market, they somehow knew when the program wouldn’t be needed any more.

I for one am thoroughly unconvinced that the Fed and the Treasury had any such clairvoyance when they set up their auction facilities, TALF programs, PPIP sales, and quantitative easing. Instead, the Fed took emergency actions and now they’re hoping they’ll go quietly into the night.

But that’s not likely to happen. For good or ill, the Constitution vests Congress with the authority to manage the currency. The Fed’s actions poached on Congressional turf, and now Congress is pushing back.

Extraordinary audits and oversight, loss of regulatory powers, and additional reporting are just the start. The Fed’s job is going to be lot more difficult. That’s a problem. Because the risk of inflation is real. We know how poisonous it can be. And as Alan Greenspan famously noted, in 25 years as Fed Chairman, not one Congressman ever lobbied for lower inflation and higher rates–ever.

Douglas R. Tengdin, CFA
Chief Investment Officer
Hit reply if you have any questions—I read them all!

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What do small European countries have in common with large US states?

Both are in fiscal distress. Countries like Greece, Ireland, and Spain are facing significant budget gaps. Greece was downgraded, Spain’s outlook is negative. States like California, New York, and Illinois are also facing downgrades and are delaying payments and issuing scrip to conserve cash.

None of these entities can issue their own currency. Oh yes, California’s scrip is a kind of currency, but it’s really an I.O.U. But because the legal tender is out of the government’s control, the governments need to find a way to plug their fiscal gaps. And therein lies the rub.

During the boom years these places got used to growing revenues and ready credit. So the governments expanded services and increased their bureaucracy. (Did you know that the California Division of Water Resources has its own staff lawyers?) When the boom ended, the revenues dried up. Reducing spending is the logical answer, but this is always harder than adding services. Unions strike; lawyers sue, and everybody votes. Budgets only get balanced when the political will to do so is present.

In the end, the political will determines what happens next. The global recession’s fallout will include some fiscal crises. The only question is where.

Douglas R. Tengdin, CFA
Chief Investment Officer
Hit reply if you have any questions—I read them all!

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A giant passed away last weekend.

So many great and good people have passed on this year, it seems that it’s been one long funeral. The latest giant to “step up” was Paul Samuelson. He was the recipient of the Nobel Prize in Economics in 1970 for his work in developing the neoclassical synthesis in economics applying Keynesian theory to classical models using the mathematics of chemistry and thermodynamics.

Samuelson was perhaps best known for his weekly columns in Newsweek, where for years he sparred with Milton Friedman, another Nobel Laureate, who approached economic questions of the day from a very different perspective. Samuelson would often note the market’s failures. Indeed, in perhaps his most famous quote he noted that the market, as a leading indicator, had predicted nine of the last five recessions. “And its mistakes were beauties!”

But perhaps his most enduring legacy was his economics textbook, which has been used for decades to train new economists. First published in 1948, it’s approaching its 20th edition and has been translated into 41 languages. By framing the questions and training future thinkers, Samuelson created the foundation for most contemporary economists.

Samuelson was present at the creation of much of modern economics, and brought sound analysis to bear on much public policy. We’re all in his debt.

Douglas R. Tengdin, CFA
Chief Investment Officer
Hit reply if you have any questions—I read them all!

Follow me on Twitter @GlobalMarketUpd

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